The Cross-Section and Time-Series of Stock and Bond Returns

The Cross-Section and Time-Series of Stock and Bond Returns

By Hanno Lustig, Ralph S.J. Koijen, Stijn Van Nieuwerburgh
April 24,2017Working Paper No. 3518

We show that bond factors, which predict future U.S. economic activity at business cycle horizons, are priced in the cross-section of U.S. stock returns. High book-to-market stocks have larger exposures to these bond factors than low book-to-market stocks, because their cash flows are more sensitive to the business cycle. Because of this new nexus between stock and bond markets, a parsimonious three-factor dynamic no-arbitrage model can be used to jointly price book-tomarket-sorted portfolios of stocks and maturity-sorted bond portfolios, while reproducing the time-series variation in expected bond returns. The business cycle itself is a priced state variable in stock and bond markets.