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

The paper contributes to a recent empirical and theoretical literature that suggests that proprietors are an important group of stockholders and that entrepreneurial risk could therefore help explain time-varying risk premia on the aggregate stock market. I use the intertemporal budget constraint of the average U.S. household to derive a cointegrating relationship between consumption and income from proprietary and non-proprietary wealth. I call this cointegrating relationship the cpy -residual. I interpret cpy as an entrepreneurial risk factor, because it mainly reflects cyclical fluctuations in proprietary income and because it is highly correlated with cross-sectional measures of idiosyncratic entrepreneurial risk. The cpy residual turns out to be a potent predictor of excess returns on the aggregate stock market in postwar U.S. data. However, this predictive power has started to decline since the beginning of the 1980s as stock market participation has widened with the advent of tax-deferable employer-sponsored pension plans and as proprietary income risk has become more easily diversifiable in the wake of state level bank deregulation