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

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Mathias Hoffmann ()

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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 GmbH in its series CESifo Working Paper Series with number CESifo Working Paper No. 1712.

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

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

Other versions of this item:

Find related papers by JEL classification:
E21 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing

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