Unemployment and Small Cap Returns: The Nexus By GIUSEPPE MOSCARINI AND FABIEN POSTEL-VINAY∗ In other work (Moscarini and Postel-Vinay, 2008,

2009a), we find a distinct cyclical pattern of the rel-ative performance of large and small businesses in terms of net job creation. Large employers destroy proportionally more jobs during and right after re-cessions, and create proportionally more jobs late in expansions, relative to small employers. Differ-ential size growth between small and large firms is strongly positively correlated with the unemployment rate. This pattern is observer both in a 1978-2005 cen-sus of U.S. employers, the Business Dynamics Statis-tics, and among listed companies, in Compustat. In this paper, we show that this cyclical pattern of relative performance is also reflected in stock returns. Specifically, we show that the difference in returns be-tween benchmark portfolios of small cap stocks and portfolios of large cap stocks is also positively corre-lated with the unemployment rate. Financial consul-tants and fund managers commonly recommend in-vesting in small cap stocks during business cycle re-coveries.1 Our findings, while consistent with that ad-vice, pertain to all phases of the business cycle. We propose an explanation of both facts based on dynamic competition between employers of differ-ent sizes and different productivities. The model is a stochastic dynamic version of the job search and wage posting model of Kenneth Burdett and Dale T. Mortensen (1998), which we analyze in detail in Moscarini and Postel-Vinay (2009b). It is a job ladder model, where smaller firms are smaller because they are less productive, offer lower wages, therefore are less attractive to workers and less successful in poach-ing workers out of competing firms. This lack of com-petitiveness on the labor market is more of a drawbac