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Labor Income and Predictable Stock Returns

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  • Tano Santos
  • Pietro Veronesi
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    Abstract

    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.

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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 8309.

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    Date of creation: May 2001
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    Handle: RePEc:nbr:nberwo:8309

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    Citations

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    Cited by:
    1. Hanno Lustig, 2004. "Housing Collateral, Consumption Insurance and Risk Premia: an Empirical Perspective (joint with Stijn Van Nieuwerburgh), forthcoming Journal of Finance," UCLA Economics Online Papers 300, UCLA Department of Economics.
    2. Randolph B. Cohen & Christopher Polk & Tuomo Vuolteenaho, 2009. "The Price Is (Almost) Right," Journal of Finance, American Finance Association, vol. 64(6), pages 2739-2782, December.
    3. Hanno Lustig & Stijn Van Nieuwerburgh, 2003. "Housing Collateral, Consumption Insurance and Risk Premia: An Empirical Perpective," NBER Working Papers 9959, National Bureau of Economic Research, Inc.
    4. Belén Nieto & Rosa Rodríguez & Rosa Rodríguez- Barrera, 2002. "The Consumption-Wealth And Book-To-Market Ratios In A Dynamic Asset Pricing Context," Working Papers. Serie EC 2002-24, Instituto Valenciano de Investigaciones Económicas, S.A. (Ivie).
    5. Ji, Tingting, 2004. "Consumer Credit Delinquency And Bankruptcy Forecasting Using Advanced Econometrc Modeling," MPRA Paper 3187, University Library of Munich, Germany.
    6. Tano Santos & Pietro Veronesi, 2004. "Conditional Betas," NBER Working Papers 10413, National Bureau of Economic Research, Inc.
    7. John H. Cochrane & Francis A. Longstaff & Pedro Santa-Clara, 2003. "Two Trees: Asset Price Dynamics Induced by Market Clearing," Levine's Bibliography 666156000000000355, UCLA Department of Economics.
    8. Christiansen, Charlotte & Joensen, Juanna Schrøter & Nielsen, Helena Skyt, 2006. "The Risk-Return Trade-Off in Human Capital Investment," IZA Discussion Papers 1962, Institute for the Study of Labor (IZA).
    9. Cochrane, John. H. & Longstaff, Francis A. & Santa-Clara, Pedro, 2004. "Two Trees," University of California at Los Angeles, Anderson Graduate School of Management qt6mt207w2, Anderson Graduate School of Management, UCLA.
    10. Hanno Lustig & Stijn Van Nieuwerburgh, 2002. "Housing Collateral, Consumption Insurance and Risk Premia," Macroeconomics 0211008, EconWPA.
    11. Ji, Tingting, 2004. "Essays on consumer portfolio choice and credit risk," MPRA Paper 3161, University Library of Munich, Germany.
    12. Hanno Lustig, 2004. "The Cross-Section of Foreign Currency Risk Premia and US Consumption Growth Risk (joint with Adrien Verdelhan)(updated February 2006)," UCLA Economics Online Papers 303, UCLA Department of Economics.
    13. Francis Longstaff & Monika Piazzesi, 2003. "Corporate Earnings and the Equity Premium," NBER Working Papers 10054, National Bureau of Economic Research, Inc.
    14. Lior Menzly & Tano Santos & Pietro Veronesi, 2002. "The Time Series of the Cross Section of Asset Prices," NBER Working Papers 9217, National Bureau of Economic Research, Inc.
    15. Hanno Lustig & Adrien Verdelhan, 2005. "The Cross-Section of Currency Risk Premia and US Consumption Growth Risk," NBER Working Papers 11104, National Bureau of Economic Research, Inc.
    16. Longstaff, Francis & Piazzesi, Monika, 2002. "Corporate Earnings and the Equity Premium," University of California at Los Angeles, Anderson Graduate School of Management qt3qn115m4, Anderson Graduate School of Management, UCLA.
    17. Hwang, Young-Soon & Min, Hong-Ghi & McDonald, Judith A. & Kim, Hwagyun & Kim, Bong-Han, 2010. "Using the credit spread as an option-risk factor: Size and value effects in CAPM," Journal of Banking & Finance, Elsevier, vol. 34(12), pages 2995-3009, December.

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