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RFS Advance Access published online on October 28, 2005
Review of Financial Studies, doi:10.1093/rfs/hhj006
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© The Author 2005. Published by Oxford University Press on behalf of the by The Society for Financial Studies. All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org.
Received January 21, 2005

Article

Labor Income and Predictable Stock Returns*

Tano Santos 1 and Pietro Veronesi 2*
1 Graduate School of Business, Columbia University and NBER
2 Graduate School of Business, University of Chicago, NBER, and CEPR

* To whom correspondence should be addressed.
Pietro Veronesi, E-mail: fpverone{at}gsb.uchicago.edu


  Abstract

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 coe.cients and large adjusted R2’s. 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.

*We thank Fernando Alvarez, Nick Barberis, John Y. Campbell, John H. Cochrane, George Constantinides, Kent Daniel, Gene Fama, Lars P. Hansen, John Heaton, Michael Johannes, Martin Lettau, Sydney Ludvigson, Lubos Pastor, Zenyu Wang and seminar participants at the 2000 NBER Summer Institute in Asset Pricing, Columbia University, Northwestern University and the University of Chicago. We thank Lior Menzly for excellent research assistance. All errors are our own.
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