This paper studies the role of heterogeneous beliefs about a non-fundamental process, which is independent of the aggregate consumption risk, in explaining the cross-section of expected returns. In the model, trading on the non-fundamental process results in redistribution of wealth and consumption along the path of the non-fundamental process. In equilibrium, a consumption-weighted sentiment determines the price of risk of the non-fundamental process, and this measure serves as a conditioning variable for tests of the cross-section. To test the model-based predictions, I develop a novel approach that exploits the close link between the cross-sectional heterogeneity in consumption and heterogeneous beliefs to identify such non-fundamental process. I find that the factor model has a significant ability to explain the cross-section of expected returns, and pessimism is associated with a high market price of risk.

Keywords: Disagreement, heterogeneous beliefs, consumption asset pricing, cross-section of equity returns

JEL classification: G10, G12, G13, E21