"Labor Income and Predictable Stock Returns"
©
Review of Financial Studies,
2006
Volume: 19
|
Issue: 1
|
Pages: 1-44
Publication type: Journal article
Research Archive Topic: Capital Markets and Investments, Corporate Finance, Risk Management
Abstract
We propose a novel economic mechanism that generates stock return predictability in both the time series and the cross-section. Investors' income has two sources, wages and dividends that grow stochastically over time. As a consequence the fraction of total income produced by wages fluctuates depending on economic conditions. We show that the risk premium that investors require to hold stocks varies with these fluctuations. A regression of stock returns on lagged values of the labor income to consumption ratio produces statistically significant coefficients and large adjusted R 2s. Tests of the model's cross-sectional predictions on the set of 25 Fama—French portfolios sorted on size and book-to-market are also met with considerable support.
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