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The Consumption–Income Ratio, Entrepreneurial Risk, and the U.S. Stock Market

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The owners of small noncorporate businesses face substantial and largely uninsurable entrepreneurial risk. They are also an important group of stock owners. This paper explores the role of entrepreneurial risk in explaining time variation in expected U.S. stock returns in the period 1952–2010. It proposes an entrepreneurial distress factor that is based on a cointegrating relationship between aggregate consumption and income from proprietary and nonproprietary wealth. This factor, referred to here as the cpy residual, signals when entrepreneurial income is low in relation to aggregate consumption and other forms of income in the economy. It is highly correlated with cross‐sectional measures of idiosyncratic entrepreneurial and default risk, and it has considerable forecasting power for the expected equity premium. However, the correlation between cpy and the stock market started to decline at the beginning of the 1980s. The decline in this correlation can be associated with increased stock market participation and with the progress of U.S. state‐level bank deregulation. This pattern is consistent with the view that entrepreneurial risk became more easily diversifiable in the wake of U.S. state‐level bank deregulation.

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Article provided by Blackwell Publishing in its journal Journal of Money, Credit and Banking.

Volume (Year): 46 (2014)
Issue (Month): 6 (September)
Pages: 1259-1292

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Handle: RePEc:wly:jmoncb:v:46:y:2014:i:6:p:1259-1292
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