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RFS Advance Access originally published online on October 28, 2005
Review of Financial Studies 2006 19(1):1-44; doi:10.1093/rfs/hhj006
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© The Author 2005. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org.

Labor Income and Predictable Stock Returns

Tano Santos
Columbia University and NBER

Pietro Veronesi
University of Chicago, NBER, and CEPR

Address correspondence to Pietro Veronesi, University of Chicago GSB, 5807 South Woodlawn Avenue, Chicago IL 60637, or e-mail: fpverone{at}gsb.uchicago.edu.

We propose a novel economic mechanism that generates stock return predictability in both the time series and the cross-section. Investors’ income has two sources, wages and dividends that grow stochastically over time. As a consequence the fraction of total income produced by wages fluctuates depending on economic conditions. We show that the risk premium that investors require to hold stocks varies with these fluctuations. A regression of stock returns on lagged values of the labor income to consumption ratio produces statistically significant coefficients and large adjusted R2s. Tests of the model’s cross-sectional predictions on the set of 25 Fama–French portfolios sorted on size and book-to-market are also met with considerable support.


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