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Labor Income and Predictable Stock Returns

  • Tano Santos
  • Pietro Veronesi
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    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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    File URL: http://www.nber.org/papers/w8309.pdf
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    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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    Publication status: published as Santos, Tano and Pietro Veronesi. "Labor Income and Predictable Stock Returns." Review of Financial Studies 19, 1 (Spring 2004): 1-44.
    Handle: RePEc:nbr:nberwo:8309
    Note: AP
    Contact details of provider: Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
    Phone: 617-868-3900
    Web page: http://www.nber.org
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