Labor Income and Predictable Stock Returns

Tano Santos and Pietro Veronesi

No 8309, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: G1 (search for similar items in EconPapers)
Date: 2001-05
New Economics Papers: this item is included in nep-fmk
Note: AP
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Citations: View citations in EconPapers (19)

Published as Santos, Tano and Pietro Veronesi. "Labor Income and Predictable Stock Returns." Review of Financial Studies 19, 1 (Spring 2004): 1-44.

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