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Labor Income and Predictable Stock Returns

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  • Tano Santos
  • Pietro Veronesi

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-super-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. Copyright 2006, Oxford University Press.

Suggested Citation

  • Tano Santos & Pietro Veronesi, 2006. "Labor Income and Predictable Stock Returns," The Review of Financial Studies, Society for Financial Studies, vol. 19(1), pages 1-44.
    • Handle: RePEc:oup:rfinst:v:19:y:2006:i:1:p:1-44
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    File URL: http://hdl.handle.net/10.1093/rfs/hhj006
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