Future labor income growth and the cross-section of equity returns

This paper examines the equilibrium relation between future labor income growth and expected asset returns; it proposes revisions in the expectation of future labor income growth as a macroeconomic state variable and suggests a three-factor model, including a factor related to this variable, along with the consumption growth factor and the market factor. The proposed future labor income growth factor is positively associated with the Fama–French factors and subsumes their explanatory power in explaining the cross-section of stock returns. These results provide a possible economic explanation for the roles of the Fama–French factors: they are compensation for higher exposure to the risk related to changes in the value of human capital. This paper also compares the performance of the proposed three-factor model with other competing models and finds that the proposed model specification better captures cross-sectional variation in average returns than any of the competing asset pricing models considered.