State-Level Business Cycles and Local Return Predictability

This study examines whether local stock returns vary with local business cycles in a predictable manner. We find that U.S. state portfolios earn higher future returns when state-level unemployment rates are higher and housing collateral ratios are lower. During the 1978 to 2009 period, geography-based trading strategies earn annualized risk-adjusted returns of 5%. This abnormal performance reflects time-varying systematic risks and local-trading induced mispricing. Consistent with the mispricing explanation, the evidence of predictability is stronger among firms with low visibility and high local ownership. Nonlocal domestic and foreign investors arbitrage away the predictable patterns in local returns in 1 year.