State-Level Business Cycles and Local Return Predictability

Abstract:     
This study examines whether local stock returns vary with local business cycles in a predictable manner. Our key conjecture is that local stock prices would decline and the average future returns would rise during local recessions as local risk aversion increases and local risk sharing abilities decline. Consistent with this conjecture, we find that U.S. state portfolios earn higher future returns when state-level unemployment rates are higher and housing collateral ratios are lower. During the 1978 to 2009 period, geography-based trading strategies that exploit this predictable pattern earn an annualized risk-adjusted performance of about five percent. This abnormal performance can be attributed to time-varying portfolio exposures to U.S. systematic risk factors and mispricing generated by coordinated local trading. Consistent with the mispricing explanation, the evidence of predictability is stronger among firms with low visibility and high local ownership. Nonlocal domestic and foreign investors arbitrage away the predictable patterns in local returns in about a year.

Number of Pages in PDF File: 89

Accepted Paper Series