The Sword of Damocles : Sparse Macroeconomic Risks and the Cross-section of Stock Returns

Our study presents novel evidence of the pricing effectiveness of sparse macroeconomic risks at the firm level and the underlying economic regimes. Specifically, we employ sparse PCA approach to aggregate macroeconomic variables from the FRED-MD database and obtain the first 8 components, namely, inflation, housing, spreads, production, employment, personal income, yields and credit; and construct the corresponding firm-level macroeconomic risk exposures as the sensitivity of the individual stock returns to the sparse economic component. We have three main findings: (i) these macro betas are materially different from firm fundamentals; (ii) the betas of inflation, production, personal income, yields and credit are strong predictors for future stock returns, and these betas have incremental information beyond micro risks; (iii) both macro and micro evidence of mispricing due to arbitrage frictions and investor sentiment can help explain the macro beta—return relations which display significantly differences across industries