Human Capital Risk, Stockholder Consumption, and Asset Returns

The success of long-run consumption risk in pricing assets is tied to labor income risk. Labor income shocks are disproportionately borne by stockholders and stockholder ultimate consumption risk captures the cross-sectional variation in asset returns, including the size and value premia. Under Epstein-Zin preferences, risk aversion as low as 6.5 is sufficient to match both the cross-sectional price of risk and the equity premium for the wealthiest stockholders. In addition, the stockholder share of aggregate consumption captures time-variation in stock and bond market returns and mirrors the dynamics of the aggregate consumption-to-wealth ratio. The results highlight the importance of stockholder consumption risk and its ties to human capital risk for asset pricing. ∗London Business School, University of Chicago and NBER, and Northwestern University and NBER, respectively. We are grateful to John Cochrane, Lauren Cohen, Josh Coval, Eugene Fama, Francisco Gomes, Lars Hansen, John Heaton, Ravi Jagannathan, Jonathan Parker, Monika Piazzesi, Jacob Sagi, and seminar participants at the Northwestern Finance lunch and the Board of Governors of the Federal Reserve for helpful comments and suggestions. We also thank Ken French for providing data. Moskowitz thanks the Center for Research in Security Prices for financial support. Correspondence to: Tobias Moskowitz, Graduate School of Business, University of Chicago, 1101 E. 58th St., Chicago, IL 60637. E-mail: tobias.moskowitz@gsb.uchicago. edu. The central insight of asset pricing theory is that differences in expected returns across assets and time can be explained by differences in risk. A cornerstone of asset pricing theory focuses on consumption risk (i.e., the consumption CAPM) and the role of human capital in making consumption and portfolio decisions. Recent evidence suggests that long-run or ultimate aggregate consumption risk, the covariance of returns with the present value of long-run changes in aggregate consumption growth, captures cross-sectional and aggregate stock returns (Parker and Julliard (2004), Bansal, Dittmar, and Lundblad (2004), Parker (2001), Bansal and Yaron (2004), Hansen, Heaton, and Li (2005)). The empirical success of long-run consumption risk raises several questions. Why does consumption take so long to adjust to news in stock returns? What are the underlying shocks driving stock returns and consumption? Do households that actually own and trade stocks care about these risks? If so, does stockholder consumption risk price assets even better? In this paper, we tie ultimate consumption risk to labor income risk and show that the consumption risk of households who hold financial assets is particularly relevant for asset pricing. We find that ultimate aggregate labor income risk, or the covariance of returns with the present value of long-run changes in labor income growth, is equally able to explain cross-sectional variation in average stock returns as ultimate aggregate consumption risk. This finding suggests that the reason aggregate consumption growth responds slowly to news in asset returns is that aggregate labor income (and total income) growth responds slowly. We then argue that analyzing who bears aggregate labor income risk is important for understanding why it is priced. Using micro-level household data from the Consumer Expenditure Survey (CEX) for the period 1982 to 2001, we show that long-run consumption growth rates of the set of agents who bear stock market risk is highly sensitive to the long-run growth rates in aggregate labor income, and exhibits significant non-linearities. As a result, the ultimate consumption risk of stockholders is even better at capturing the cross-sectional variation of average stock returns. There are statistically and economically significant differences across assets in their covariation with long-run stockholder consumption growth. In particular, small and value stocks earn low returns when the future consumption growth of stockholders is low, requiring a premium for stockholders to bear this risk. Following Bansal and Yaron (2004) and Hansen, Heaton, and Li (2005) we interpret our findings within a framework that adopts Epstein-Zin (1989) and Weil (1989) preferences, allowing for the separation of the elasticity of intertemporal substitution (EIS) from risk aversion. In this setting,