Sectoral Labor Reallocation and Return Predictability

Abstract

Sectoral labor reallocation shocks change the optimal allocation of workers across industries. We show that the cross-sectional dispersion in industry-specific stock returns (CSV) serves as a good proxy for this type of labor market shocks. CSV predicts aggregate unemployment growth as well as the ex-post mismatch between job seekers and vacancies across sectors. We find that CSV has strong and robust predictive power for future stock market returns and easily outperforms 12 well-known existing predictive variables. In predictive regressions, the one-year out-of-sample R^2 is as high as 12.6%. We propose a production-based asset pricing model in which sectoral labor reallocation shocks generate return predictability through time–varying exposure to aggregate productivity risk. New testable implications are supported by the data.

Keywords: Financial Markets and the Macroeconomy, Return Predictability, Sectoral Shifts, Production-Based Asset Pricing

JEL Classification: G12, G17