The Substitutability of Labor : Implications for the Cross-Section of Stock Returns

We examine the cross-sectional relation between log growth in physical capital to log growth in labor and subsequent stock returns. The ratio is a strong predictor of negative future abnormal returns. This relation strengthens with measures of financing constraint while remaining robust to previously provided determinants of returns. A ratio-based 2-factor model outperforms common models explaining various asset pricing anomalies, indicating that anomalies reflect cross-sectional variation in this ratio. We interpret the findings as outcomes reflecting displacements on the production isoquant, and show an investment-based asset pricing model with financing constraint generates the aforementioned pattern in returns