Proprietary Income and the Predictability of Stock Returns

The paper provides an empirical characterization of the consump-tion- wealth ratio in terms of a cointegrating relationship between con-sumption and income from proprietary and non-proprietary wealth. This cointegrating relationship — that I call the cpy-residual — can mainly be associated with temporary fluctuations in proprietary in-come. It is also potent predictor of excess returns on the S&P 500 and the CRSP index of stock prices at horizons beyond two years. This forecasting power is unrelated to the fact that proprietary income may correlate with dividends and earnings over the business cycle. These findings provide a time-series counterpart to the results put forward by Heaton and Lucas (2000). They can be interpreted in the light of recent theoretical models that suggest that entrepreneurial income may be an important source of non-insurable risk for those households that own stocks and that it may therefore help explain time-varying risk premia on stocks