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.
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Hanno Lustig & Stijn Van Nieuwerburgh & Adrien Verdelhan, 2008.
"The Wealth-Consumption Ratio,"
NBER Working Papers
13896, National Bureau of Economic Research, Inc.
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