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Proprietary Income, Entrepreneurial Risk, and the Predictability of U.S. Stock Returns

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  • Mathias Hoffmann

Abstract

Small businesses tend to be owned by wealthy households. Such entrepreneur households also own a large share of U.S. stock market wealth. Fluctuations in entrepreneurs’ hunger for risk could therefore help explain time variation in the equity premium. The paper suggests an entrepreneurial distress factor that is based on a cointegrating relationship between consumption and income from proprietary and non-proprietary wealth. I call this factor the cpy residual. It reflects cyclical fluctuations in proprietary income, is highly correlated with cross-sectional measures of idiosyncratic entrepreneurial risk and has considerable forecasting power for U.S. stock returns. In line with the theoretical mechanism, the correlation between cpy and the stock market has been declining since the beginning of the 1980s as stock market participation has widened and as entrepreneurial risk has become more easily diversifiable in the wake of U.S. state-level bank deregulation.

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Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 1712.

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Date of creation: 2006
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Handle: RePEc:ces:ceswps:_1712

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Keywords: non-insurable background risk; entrepreneurial income; equity risk premium; long-horizon predictability;

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Cited by:
  1. Benjamin R. Auer, 2012. "Lassen sich CAPM, HCAPM und CCAPM durch konsumbasierte zeitvariable Parameterspezifikation rehabilitieren?," Journal of Economics and Statistics (Jahrbuecher fuer Nationaloekonomie und Statistik), Justus-Liebig University Giessen, Department of Statistics and Economics, Justus-Liebig University Giessen, Department of Statistics and Economics, vol. 232(5), pages 518-544, September.
  2. Thomas Nitschka, 2008. "Idiosyncratic Consumption Risk and Predictability of the Carry Trade Premium: Euro Area Evidence," IEW - Working Papers, Institute for Empirical Research in Economics - University of Zurich 387, Institute for Empirical Research in Economics - University of Zurich.
  3. Britta Hamburg & Mathias Hoffmann & Joachim Keller, 2005. "Consumption, Wealth and Business Cycles in Germany," CESifo Working Paper Series 1443, CESifo Group Munich.
  4. Mathias Hoffmann & Thomas Nitschka, 2009. "Securitization of Mortgage Debt, Asset Prices and International Risk Sharing," CESifo Working Paper Series 2527, CESifo Group Munich.

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