Proprietary Income, Entrepreneurial Risk, and the Predictability of U.S. Stock Returns

47 Pages Posted: 23 May 2006

See all articles by Mathias Hoffmann

Mathias Hoffmann

University of Zurich - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute)

Date Written: May 2006

Abstract

Small businesses tend to be owned by wealthy households. Such entrepreneur households also own a large share of U.S. stock market wealth. Fluctuations in entrepreneurs' hunger for risk could therefore help explain time variation in the equity premium. The paper suggests an entrepreneurial distress factor that is based on a cointegrating relationship between consumption and income from proprietary and non-proprietary wealth. I call this factor the cpy residual. It reflects cyclical fluctuations in proprietary income, is highly correlated with cross-sectional measures of idiosyncratic entrepreneurial risk and has considerable forecasting power for U.S. stock returns. In line with the theoretical mechanism, the correlation between cpy and the stock market has been declining since the beginning of the 1980s as stock market participation has widened and as entrepreneurial risk has become more easily diversifiable in the wake of U.S. state-level bank deregulation.

Keywords: non-insurable background risk, entrepreneurial income, equity risk premium, long-horizon predictability

JEL Classification: E21, E31, G12

Suggested Citation

Hoffmann, Mathias, Proprietary Income, Entrepreneurial Risk, and the Predictability of U.S. Stock Returns (May 2006). CESifo Working Paper Series No. 1712, Available at SSRN: https://ssrn.com/abstract=903866

Mathias Hoffmann (Contact Author)

University of Zurich - Department of Economics ( email )

Zuerich, 8006
Switzerland

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

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