Review of Financial Studies Vol. 19 No. 1 2006
Labor Income and Predictable Stock Returns
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 R2s. 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.
- Volume
- 19
- Issue
- 1
- Pages
- 1-44
- Sources
- bibtex:phds-export.bib