The Bond Risk Premium and the Cross-Section of Equity Returns

The cross-section of returns of stock portfolios sorted along the book-to-market dimension can be understood with a one-factor model. The factor is the nominal bond risk premium, best measured as the Cochrane-Piazzesi (2005, CP) factor. This paper ties the pricing of stocks in the cross-section to the pricing of government bonds of various maturities, two literatures that have been developed largely in isolation. A parsimonious stochastic discount factor model can price both the cross-section of stock and bond returns. The mean average pricing error across 5 bond and 10 book-to-market stock portfolio returns is less than 60 basis points per year. The model also replicates the dynamics of bond yields as well as the time-series predictability of stock and bond returns. Its key feature is a non-zero risk price on the state variable that governs the bond risk premium. Value stocks are riskier because their returns are high when the bond risk premium is high. We trace back this risk to the fundamentals: CP predicts lower dividend growth on value stocks and higher dividend growth on growth stocks over the next 1-8 quarters. Since CP increases sharply over the course of a recession, it suggests that value stocks carry high returns because they have low cash-flow growth exactly when investors need it the most. We explore equilibrium asset pricing models’ ability to jointly account for the stock and bond returns patterns we document in the data. JEL codes: G12.