Hypothesis for Explaining the Equity Premium Puzzle and the Success of the U.S Stock Market (First Draft)

Brennan Dwyer

 

 

The equity premium puzzle is seen as one of the biggest and most important unsolved mysteries in financial economics. In summary, the equity premium puzzle is the unsolved mystery of why the U.S stock market has continuously outperformed the returns of U.S government bonds for at least over the past 100 years. The term equity premium is defined as the gap between the returns of the U.S stock market and the returns of U.S government bonds. Economists have tried to rationalize the equity premium puzzle through different theories such as the theory that investors get more returns for their willingness to take more risks. Though many economists have attempted to solve the equity premium puzzle, there simply hasn’t been a strong enough explanation provided to solve the equity premium puzzle. This paper will attempt to give a possible solution to the equity premium puzzle, as well as explain why the U.S stock market has performed so well.

This paper states the hypotheses that the U.S stock market has been experiencing demand pull inflation because of the increase in total gross domestic savings over time (in dollars, not percentage of GDP), and there likely isn’t even a premium as a result.

Demand pull inflation is defined as when the aggregate demand of an economy exceeds the aggregate supply of an economy. In this paper, the term ‘demand pull inflation’ is used for the stock market, since this paper sees the stock market as its own economy, with the terms aggregate demand and aggregate supply being a good way to describe the stock market in this scenario. It is likely commonly agreed upon that within the stock market, the stocks being sold are represented as the supply, and the stocks being bought are represented as the demand.

If within the long run there has been an increase in gross domestic savings, it would make logical sense for a large portion of the savings to be used to buy more stocks at higher prices (aggregate demand), which would outpace the amount of stocks being sold in the long run (aggregate supply), thus causing demand pull inflation of the stock market. In other words, this paper has the assumption that a large portion of the increase in gross domestic savings is invested towards the stock market.

To prove this hypothesis, Figure 1 shows a very strong correlation between the gross domestic savings and the market capitalization of listed domestic companies within the U.S over several recent decades. The data for the two variables was collected from “data.worldbank.org”. However, the two separate variables that were collected from this source were put together and analyzed as part of the work for this paper.

equity premium puzzle picture

Figure 1– Scatterplot model of the relationship between gross domestic savings and the market capitalization of listed domestic companies within the U.S from 1980-2016 in dollars.

Data used from “data.worldbank.org”

 

Despite the observation that in Figure 1 the gross domestic savings are not nearly as large in monetary value as the market capitalization of listed domestic companies, this paper has the hypothesis that there doesn’t need to be quite as much of an increase in the aggregate demand for the stock market to match the increase for the total value of the market capitalization. It is logical to assume that many stocks within the stock market aren’t frequently bought or sold and are held onto by certain investors for the long-run, therefore only a certain fraction of the stocks in the stock market would need to be demanded at a higher price to cause the whole market capitalization to go up.

It is important however to bear in mind that the difference in monetary value between the two variables on Figure 1 are not that different in magnitude, with the values for gross domestic savings ranging from 6.53E+11 up to 3.18E+12 in dollars, and the values for market capitalization ranging from 1.26E+12 up to 2.74E+13 in dollars.

In conclusion, this paper has the hypothesis that the U.S stock market has been experiencing demand pull inflation because of the increase in total gross domestic savings over time. From a logical standpoint this could explain that the premium in the equity premium puzzle is likely only due to the demand pull inflation of the U.S stock market, with the demand pull inflation being an result of the increase in gross domestic savings (in dollars). That could even mean that there simply isn’t a premium. Again, this paper has the assumption that a large portion of the increase in gross domestic savings is invested towards the stock market.

 

 

 

Works Cited

Gross Domestic Savings (Current US$). data.worldbank.org/indicator/NY.GDS.TOTL.CD?end=2016&locations=US&start=1980&view=chart.

Market Capitalization of Listed Domestic Companies (% of GDP). data.worldbank.org/indicator/CM.MKT.LCAP.GD.ZS?end=2016&locations=US&start=1980.

 

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