Labor Hiring and Discount Rates*

Using a standard production model with labor market frictions, we show that firms’ optimal hiring is a forward looking decision that depends on aggregate discount rates and future dividends. Consistent with the model, we find empirically that: (a) the aggregate hiring rate of public listed firms negatively predicts aggregate stock market excess returns (discount rates) and aggregate cash-flows both in-sample and out-ofsample; (b) large, low market beta, and old firms explain most of the return predictability of the aggregate hiring rate for stock returns; and (c) the explanatory power of the aggregate hiring rate for returns is not explained by traditional cash-flow based measures of performance. Taken together, our results demonstrate the significance of labor hiring to understand the dynamic nature of discount rates and cash flows. *This version: December 2017. †Frederico Belo is at the University of Minnesota, Department of Finance, and NBER. Andres Donangelo is at the University of Texas at Austin, Finance Department. Xiaoji Lin is at the Ohio State University, Finance Department. Ding Luo is at the University of Minnesota, Department of Finance. If today prices are high relative to dividends, then, unless future dividend growth is higher than usual, future returns will be lower than usual. This well-established idea, which was formalized in Shiller’s seminal (1981) paper, implies that discount rates or cash flow growth– or a combination of the two–should be predictable. Extensive research studies the predictive power of many variables. The accumulated body of evidence now provides evidence in favor of discount rate predictability and against cash flow growth predictability, at least at at the aggregate level. However, baring a few exceptions that we discuss below, less attention was given to the study of the predictive power of labor market variables. In this paper, we help close this gap. In many–if not most–existing asset pricing models, firms’ hiring and firing activity only responds to shocks to present cash flows and is thus unable to predict shocks to discount rates. The presence of adjustment costs and other labor demand frictions make hiring and firing decisions forward looking and potentially informative about discount rate and future cash flows.1 To establish the theoretical link between labor hiring, and stock return and dividend predictability, we consider a simplified version of the model in Belo, Lin, and Bazdresch (2014) (henceforth BLB) who consider an economy with labor market frictions. In the model, labor hiring and firing is costly for firms, which is captured through an adjustment cost function. Firms’ take prices as given and choose how many workers to hire or fire to maximize the value of the firm. In the model, the firm’s first order condition for hiring expresses a relation between the firm’s optimal hiring rate, the expected future firm profitability (measured by firm’s dividends relative to its labor stock, and also future dividend growth), and the expected future stock return. We use this relationship to guide the empirical analysis. We use shortand long-horizon predictive regressions using the aggregate (computed across different groups of firms) hiring rate to predict aggregate stock market excess returns (discount rates) and dividends. 1See for example Merz and Yashiv (2007) for an early discussion of this idea.