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 R 2s. 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.
Santos, Tano, and Pietro Veronesi. "Labor Income and Predictable Stock Returns." Review of Financial Studies 19, no. 1 (Spring 2006): 1-44.
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