Labor Income Risk and the Cross-Section of Expected Returns

TL;DR

This paper investigates how sectoral shift risks, proxied by cross-industry dispersion, influence expected stock returns and unemployment, revealing a significant return spread linked to sectoral reallocation uncertainty.

Contribution

It introduces cross-industry dispersion as a proxy for unemployment risk from sectoral shifts and demonstrates its cross-sectional impact on stock returns beyond common factors.

Findings

High sensitivity stocks have 5.9% lower annualized returns.

Abnormal returns of 3.5% are unexplained by standard models.

CID predicts unemployment, linking sectoral shifts to asset prices.

Abstract

This paper explores asset pricing implications of unemployment risk from sectoral shifts. I proxy for this risk using cross-industry dispersion (CID), defined as a mean absolute deviation of returns of 49 industry portfolios. CID peaks during periods of accelerated sectoral reallocation and heightened uncertainty. I find that expected stock returns are related cross-sectionally to the sensitivities of returns to innovations in CID. Annualized returns of the stocks with high sensitivity to CID are 5.9% lower than the returns of the stocks with low sensitivity. Abnormal returns with respect to the best factor model are 3.5%, suggesting that common factors can not explain this return spread. Stocks with high sensitivity to CID are likely to be the stocks, which benefited from sectoral shifts. CID positively predicts unemployment through its long-term component, consistent with the hypothesis that CID is a proxy for unemployment risk from sectoral shifts.