Tradable Macro Risk Factors and the Cross-Section of Stock Returns

Abstract

We show that value and small stocks have higher expected returns due to their exposure to a factor linked to dividend growth and its risk premium – a tradable dividend growth factor constructed using dividend swap data. Hence, growth risks are the only source of their risk premia. The equity market portfolio can be decomposed into several tradable aggregate risk factors, but only one of these factors is priced in the cross-section of size- and value-sorted portfolios. We propose two alternative approaches to test the post-1963 cross-sectional implications of the model based on either the stability of portfolio betas or ability to form factor mimicking portfolios. In both cases, our results imply that only dividend growth news and/or expected return news associated with dividend growth matter in this cross-section, while other cash flow news (for instance, level of dividends) and other expected returns news (for instance, changes in government bond yields) do not matter. We find that a tradable dividend level factor is also priced in the cross-section of other portfolios (sorted on dividend yield, earnings yield and cash-flow-to-price). Results are robust to the inclusion of other tradable aggregate factors such as bond returns, inflation breakeven returns, implied volatility returns as well as credit risk, banking sector risk, and liquidity risk factors.