Labor Income and Predictable Stock Returns

We propose and test a novel economic mechanism that generates stock return predictability on both the time series and the cross section. In our model, investors' income has two sources, wages and dividends, that grow stochastically over time. As a consequence, the fraction of total income produced by wages changes over time de-pending on economic conditions. We show that as this fraction fluctuates, the risk premium that investors require to hold stocks varies as well. We test the main implications of the model and find substantial support for it. A regression of stock returns on lagged values of the labor income to consumption ratio produces statistically significant coefficients and adjusted R2 's that are larger than those generated when using the dividend price ratio. Tests of the cross sectional implication find considerable improvements on the performance of both the conditional CAPM and CCAPM when compared to their unconditional counterparts.

[1]  Michele Boldrin,et al.  Habit Persistence, Asset Returns, and the Business Cycle , 2001 .

[2]  E. Fama,et al.  Common risk factors in the returns on stocks and bonds , 1993 .

[3]  James D. Hamilton Time Series Analysis , 1994 .

[4]  Jay Shanken,et al.  Intertemporal asset pricing: An Empirical Investigation , 1990 .

[5]  S. P. Kothari,et al.  Nonstationary expected returns: Implications for tests of market efficiency and serial correlation in returns , 1989 .

[6]  R. Hodrick Dividend Yields and Expected Stock Returns: Alternative Procedures for Interference and Measurement , 1991 .

[7]  John Y. Campbell,et al.  Consumption-Based Asset Pricing , 2002 .

[8]  R. Engle,et al.  Time-Varying Betas and Asymmetric Effect of News: Empirical Analysis of Blue Chip Stocks , 1999 .

[9]  J. Campbell Stock Returns and the Term Structure , 1985 .

[10]  J. Campbell,et al.  By Force of Habit: A Consumption‐Based Explanation of Aggregate Stock Market Behavior , 1995, Journal of Political Economy.

[11]  E. Fama,et al.  BUSINESS CONDITIONS AND EXPECTED RETURNS ON STOCKS AND BONDS , 1989 .

[12]  R. Stambaugh,et al.  Tests of Asset Pricing with Time‐Varying Expected Risk Premiums and Market Betas , 1987 .

[13]  Donald B. Keim,et al.  Predicting returns in the stock and bond markets , 1986 .

[14]  R. Shiller,et al.  The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors , 1986 .

[15]  E. Fama,et al.  Permanent and Temporary Components of Stock Prices , 1988, Journal of Political Economy.

[16]  Lilian Ng Tests of the CAPM with Time-Varying Covariances: A Multivariate GARCH Approach , 1991 .

[17]  J. Danthine,et al.  Labour Relations and Asset Returns , 2002 .

[18]  J. Campbell Asset Pricing at the Millennium , 2000, The Journal of Finance.

[19]  P. Phillips Understanding spurious regressions in econometrics , 1986 .

[20]  A. Timmermann Excess Volatility and Predictability of Stock Prices in Autoregressive Dividend Models with Learning , 1996 .

[21]  R. Lucas ASSET PRICES IN AN EXCHANGE ECONOMY , 1978 .

[22]  J. Cochrane,et al.  Where is the market going ? Uncertain facts and novel theories , 1997 .

[23]  A. Lo,et al.  THE ECONOMETRICS OF FINANCIAL MARKETS , 1996, Macroeconomic Dynamics.

[24]  R. Green,et al.  Optimal Investment, Growth Options, and Security Returns , 1998 .

[25]  Richard Roll,et al.  A Critique of the Asset Pricing Theory''s Tests: Part I , 1977 .

[26]  J. Robert,et al.  SHILLER, . Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?, The American Economic Review, , . , 1981 .

[27]  John H. Cochrane,et al.  A Cross-Sectional Test of an Investment-Based Asset Pricing Model , 1996, Journal of Political Economy.

[28]  R. Shiller,et al.  Stock Prices, Earnings and Expected Dividends , 1988 .

[29]  Francesco Franzoni Where is Beta Going? The Riskiness of Value and Small Stocks , 2002 .

[30]  Andrew Ang,et al.  Stock Return Predictability: Is it There? , 2001 .

[31]  J. Wooldridge,et al.  A Capital Asset Pricing Model with Time-Varying Covariances , 1988, Journal of Political Economy.

[32]  James N. Bodurtha,et al.  Testing the CAPM with Time-Varying Risks and Returns , 1991 .

[33]  Jay Shanken On the Estimation of Beta-Pricing Models , 1992 .

[34]  Prospect Theory and Asset Prices , 1999 .

[35]  John Y. Campbell,et al.  Asset Prices, Consumption, and the Business Cycle , 1998 .

[36]  Campbell R. Harvey,et al.  The Variation of Economic Risk Premiums , 1990, Journal of Political Economy.

[37]  John Y. Campbell,et al.  Understanding Risk and Return , 1993, Journal of Political Economy.

[38]  E. Fama,et al.  The Cross‐Section of Expected Stock Returns , 1992 .

[39]  E. Fama,et al.  Risk, Return, and Equilibrium: Empirical Tests , 1973, Journal of Political Economy.

[40]  Allan Timmermann,et al.  How Learning in Financial Markets Generates Excess Volatility and Predictability in Stock Prices , 1993 .

[41]  Serena Ng,et al.  Unit Root Tests in ARMA Models with Data-Dependent Methods for the Selection of the Truncation Lag , 1995 .

[42]  M. Lettau,et al.  Resurrecting the (C)Capm: A Cross-Sectional Test When Risk Premia Wre Time-Varying , 1999 .

[43]  J. Stock,et al.  Drawing Inferences from Statistics Based on Multi-Year Asset Returns , 1989 .

[44]  R. C. Merton,et al.  AN INTERTEMPORAL CAPITAL ASSET PRICING MODEL , 1973 .

[45]  J. Cochrane,et al.  New Facts in Finance , 1999 .

[46]  Ravi Jagannathan,et al.  An Asymptotic Theory for Estimating Beta‐Pricing Models Using Cross‐Sectional Regression , 1998 .

[47]  Martin D. D. Evans Expected Returns, Time-Varying Risk and Risk Premia , 1994 .

[48]  W. Ferson Changes in Expected Security Returns, Risk, and the Level of Interest Rates , 1989 .

[49]  R. Jagannathan,et al.  The Conditional CAPM and the Cross-Section of Expected Returns , 1996 .

[50]  Peter Bossaerts,et al.  A General Equilibrium Model of Changing Risk Premia: Theory and Tests , 1989 .

[51]  P. Veronesi How Does Information Quality Affect Stock Returns? , 1999 .

[52]  M. Watson,et al.  Testing for Cointegration When Some of the Contributing Vectors are Known , 1994 .

[53]  E. Fama,et al.  Dividend yields and expected stock returns , 1988 .

[54]  Owen A. Lamont Earnings and Expected Returns , 1996 .

[55]  Campbell R. Harvey Time-Varying Conditional Covariances in Tests of Asset Pricing Models , 1989 .

[56]  R. Mehra,et al.  THE EQUITY PREMIUM A Puzzle , 1985 .

[57]  E. Fama,et al.  Industry costs of equity , 1997 .

[58]  E. Fama,et al.  Human capital and capital market equilibrium , 1977 .

[59]  Sydney C. Ludvigson,et al.  Consumption, Aggregate Wealth and Expected Stock Returns , 1999 .

[60]  Mark Rubinstein,et al.  The Valuation of Uncertain Income Streams and the Pricing of Options , 1976 .

[61]  J. Berk A Critique of Size-Related Anomalies , 1995 .

[62]  Sydney C. Ludvigson,et al.  Understanding Trend and Cycle in Asset Values , 2000 .