The Cross-Section and Time-Series of Stock and Bond Returns

Value stocks have higher exposure to innovations in the nominal bond risk premium than growth stocks. Since the nominal bond risk premium measures cyclical variation in the market’s assessment of future output growth, this results in a value risk premium provided that good news about future output lowers the marginal utility of wealth today. In support of this mechanism, we provide new historical evidence that low return realizations on value minus growth, typically at the start of recessions when nominal bond risk premia are low and declining, are associated with lower future dividend growth rates on value minus growth and with lower future output growth. Motivated by this connection between the time series of nominal bond returns and the cross-section of equity returns, we propose a parsimonious three-factor model that jointly prices the cross-section of returns on portfolios of stocks sorted on book-to-market dimension, the cross-section of government bonds sorted by maturity, and time series variation in expected bond returns. Finally, a structural dynamic asset pricing model with the business cycle as a central state variable is quantitatively consistent with the observed value, equity, and nominal bond risk premia.