Hypothesis for Explaining the Equity Premium Puzzle and the Success of the U.S Stock Market

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.

 

List of Possible Bipartisan Compromises

Here are a list of possible bipartisan compromises that I have put some deep thought into. I really think that it is important that our politicians come together and create more bipartisan compromises that are a win-win for both parties. Otherwise, if you think about it analytically, in the long run legislation will likely continue to be repealed and replaced amongst both political parties. If we want there to be anything done long-term, there needs to be more of a push for everyone in congress to come together! 

  •  A gradual increase in minimum wage (as a percentage increase on the current minimum wage of each state) in return for tax credits for businesses that match up to the extra cost of the higher minimum wages that they are forced to pay. The tax credits would be funded by a combination of cuts in spending towards administrative costs and fees for healthcare, and from the increase in tax revenue due to the workers being paid higher wages.

  •  Cuts in spending towards the large costs of unnecessary administrative costs and fees for healthcare, in return for more price ceilings and regulation on the prices of pharmaceutical drugs in the pharmaceutical industry.

  •  More border security in return for a higher intake of immigrants.

  •  A flat increase on the capital gains tax (regardless of the amount earned income from investments) in return for paying off more of the national debt, and more relief towards student loan debt, (especially on loans that are most frequently defaulted on.)

  •  More emphasis and more of an expansion on online k-12 learning, with the money that is saved from more online learning going towards funding normal k-12 education.

  • A carbon tax for businesses that are releasing high amounts of carbon into the atmosphere, and a tax credit for corporations that are reducing their carbon levels, leaving total tax revenue unchanged.

  • More sex education and awareness on how to prevent from getting an STD or becoming pregnant, and leave current abortion and planned parenthood laws the same as they already are.

  •  More background checks and mental health screenings, as well as limitations on the ownership of certain types of guns that statistically lead to the most gun deaths and mass shootings, in return for the protection of many second amendment rights as well as more freedoms to where you can own and carry a gun.

  •  More funding towards correctional education and other programs that are statistically proven to reduce recidivism rates, that could in the long run save money for the government due to the lower recidivism rates and lower crime rates.

List of Economic Questions from an 18 Year Old Passionate About Economics

Here is a list of economic and political questions that I have come up with over time, and wish to potentially solve one day, or learn about from others. Some of these may be unsolved, though I am not completely sure!

 

  • Is the economic growth or stability of an economy affected by the percentage of the GDP that is made up of government expenditure, with all other things remaining consistent? If so, then what is the equilibrium amount of government expenditure as a percentage of the GDP that leads to the most economic growth or stability?
  • Is the economic growth or stability of an economy affected by how equal or unequal the income or wealth distribution is? If so, then is there an equilibrium point for how evenly distributed the income or wealth distribution is that leads to the most economic stability or growth?
  • Is the ‘trickle-up theory’ or the ‘trickle-down theory’ true? Could they both be true? Does one lead to more economic growth, stability, then the other? Could they both be equally important?
  •  Is there a universal underlying factor behind how or why the business cycle occurs? Is there an equation that can prove that? If not, then what are the main contribution factors that cause it, and can help predict it?
  •  Can a recession or economic decline occur largely from the process of a particular sector of the economy significantly innovating and growing, which leads to higher wages and wealth in the economy that may cause demand-pull inflation to occur on other sectors of the economy?
  •  Does an increase in innovation and output for the factors of production that ends up producing more finished goods for one business or industry lead to more output for other businesses or industries as well? Ex: Does growth from the gun industry help lead to growth for the butter industry?
  • What has caused the stock market to exponentially increase over the past century by such a large amount, especially compared to the Real GDP or Bond rates? Could the stock market simply just be very elastic, causing it to react very elastic to people selling their stocks?
  •  Is the total wealth in the economy not very liquid, considering that if the wealth was suddenly used for consumption, the economy would be too scarce to provide for the sudden demand for many different goods and services?
  • Similar to the field of game theory, could there be a field in mathematics that studies the concept of comprise, which would lead to the theory that politicians would be better off if they compromised more?

Model of Unemployment Rate vs Minimum Wage to Median Wage Ratio of Different Countries

(Down below is my first official economics paper I have written. Please let me know what you think or if you have any feedback!)

 

 

This model was created to show the relationship between unemployment rates and the minimum wage to median wage ratio of different countries listed from the OECD. It is interesting to note that generally in the economic community, it is often theorized that a higher minimum wage correlates with a higher unemployment rate. For example, in many European nations they are known to have a more progressive approach to their economy, and are known to have higher rates for their minimum wage in comparison with the U.S. Also, the Euro-zone tends to have a higher unemployment rate then the U.S (Liberty Street Economics).

To specifically describe this model, the independent variable is the minimum wage to median wage ratio. This ratio for each country was data taken from the OECD library. The dependent variable is the unemployment rate of each given country. This data on the unemployment rate was taken from the World Facebook, which was given on the CIA’s official website. It is interesting to note how significant the positive correlation is between having a higher minimum to median wage ratio, in comparison with having a higher unemployment rate. In other words, the countries that tend to have a higher minimum to median ratio tend to have a higher unemployment rate. Though it is unclear which variable causes the other variable, again many individuals in the economics community would likely agree that a higher minimum wage leads to a higher unemployment rate. One factor that stands out about this model compared to other models on minimum wage to unemployment is this model shows how high the minimum wage is relative to its own countries median wage, rather than unfairly comparing minimum wages across the world without considering how rich or poor the country is itself., As a result, this aspect of this model helps to give a better idea for a higher or lower minimum wage in comparison to a higher or lower unemployment rate.

 

min wage to median wage chart

 

Down below is the list of data that was used to create the model. It is important to note that two countries that were originally in this data set were later removed due to being such outliers in their unemployment rates. Rather then the countries being in alphabetical order, they are put from least to greatest in terms of their minimum to median wage ratio. This was done intentionally to help create the model. Again, the data on the minimum wage to median wage ratios was taken from the OECD library, and the data on the unemployment rates were taken from the World Facebook which was on the CIA’s website.

 

Country Minimum to Median wage Unemployment Rate
United States 0.35 4.4
Mexico 0.37 3.6
Czech Republic 0.4 2.3
Japan 0.4 2.9
Estonia 0.41 8.4
Ireland 0.45 6.4
Netherlands 0.45 5.1
Canada 0.46 6.5
Germany 0.47 3.8
Slovak Republic 0.48 7.4
United Kingdom 0.49 4.4
Belgium 0.5 7.5
Korea 0.5 3.8
Hungary 0.51 4.4
Latvia 0.51 9
Australia 0.54 5.6
Poland 0.54 4.8
Lithuania 0.54 7
Luxembourg 0.55 5.9
Israel 0.58 4.3
Portugal 0.58 9.7
Slovenia 0.59 6.8
France 0.61 9.5
New Zealand 0.61 4.9
Chile 0.69 7
Costa Rica 0.69 8.1
Turkey 0.76 11.2
Colombia 0.86 9.3

 

 

 

 

 

 

 

 

 

 

 

 

Works Cited

“COUNTRY COMPARISON :: UNEMPLOYMENT RATE.” Central Intelligence Agency, Central Intelligence Agency, http://www.cia.gov/library/publications/the-world-factbook/rankorder/2129rank.html.

Klitgaard, Thomas, and Richard Peck. “Comparing U.S. and Euro Area Unemployment Rates   Liberty Street Economics.” Liberty Street Economics, libertystreeteconomics.newyorkfed.org/2014/02/comparing-us-and-euro-area-unemployment-rates.html.

“Minimum Wages Relative to Median Wages.” OECD Instance, OECD ILibrary, http://www.oecd-ilibrary.org/employment/data/earnings/minimum-wages-relative-to-median-wages_data-00313-en.

 

I Just Self Published a Book that I Think Other Teens My Age Could Learn From

After over 3 years of fun but hard work, I finally self published a personal finance book for teens. Here is why teens should know what my book teachers…

 

One of the specific topics that I am passionate about is personal finance. There are many different aspects of personal finance that I find to be interesting. Whether it’s budgeting on different income levels, finding the best ways to gain long term wealth, or even learning advice on colleges and careers, this all comes across interesting to me.

Starting at the age of 14, I decided to write a personal finance book, specifically geared towards teenagers. Not only did I choose to write this book because it forced me to learn more about the subject and write something that I am passionate about, but also I believe that not enough teens are taught personal finance.

Personal Finance shouldn’t be a subject that is taught only primarily to people that are older and fairly well into their careers. I believe that this subject should also be taught towards a younger audience. This should be taught so that these kids not only make wise choices heading into adulthood, but also so they dont make big financial mistakes.

Take credit cards as an example of something that needs to be taught, which I talk about in my book…

To many teenagers and young adults, credit cards may come across as unlimited money. However, teenagers, (and adults) can fall into a trap where they end up spending too much with their credit card, and end of accumulating a large amount of credit card debt that they struggle to pay off later on. It is good to use a credit card and establish good credit. However, you have to remember to not overspend, and make the monthly payments on time!

The title of the chapter that I talked largely about debt is called “Spam and Scams (Yikes!)”. It may be a cheesy title, but hey, I thought it was cute… 🙂

Some other examples of topics that should be taught to a many youngsters like me, is compound interest, budgeting, college, and even investing in assets such as the stock market. Though some teens my already know how to budget, not get into debt, and even how to put money towards certain investment, I believe that many teens aren’t informed on these subjects, and may want to learn this stuff in a fun and understandable way.

If you or a teen you know is interested, here is link to my e-book:

Personally, I See a Big Recession Coming

Though many seem optimistic about our economy, we may be in for a big bubble, and one that keeps on building up.

(Please bare in mind that this post is only describing a theory I have about our economy. Please don’t take this as serous financial advice! No one can truly and safely predict the economy, or the stock market.)

I have been making an interesting observation lately. From looking at the media, people’s voices, or even different economic charts, I have noticed that many people are thinking that the economy is doing great, and will continue to. I will not lie, the economy is doing fairly well and has recovered dramatically since the 2008 recession. GDP is at a healthy rate, also unemployment is very low. However, history repeats itself, and it doesn’t make sense economically in my opinion for the stock market to continue to go up much longer.

The stock market seems way overvalued, and I question why it has seen such a drastic growth over the past several years. It’s necessary for the stock market to correct itself every once in a while, but my theory is that if you wait too long for it to go down, it can have major consequences on businesses, and the economy.

Here are 3 factors that I believe are making the stock market continue to go up in the short run, but keep on postponing a market correction, and will lead to a terrible recession…

1. Federal Interest Rates Remain too Low, Possibly Overheating the Economy

Considering how low-interest rates have remained, being at only 1.5% percent now, and even lower not too long ago, I think this may be contributing to a the stock market becoming too overvalued, with possibly too much growth in lending and borrowing to businesses. It also isn’t good news if you don’t have much elbow row to decrease the Federal Interest rates to bring back economic growth, when there is a recession.

2. The Rich are Getting Richer

So why do I think that rising inequality would lead to too much short-term growth in the stock market? Well consider this… The wealthy have a large amount of their assets invested in capital markets. As they continue to have a larger share of the economy, that means more money is put away in the stock market and other investments, again leading to this short term growth in these investments.

3. Recent Tax Cuts to Big Corporations May Help Bring Their Stocks Up for the Final Stretch

Since congress recently passed big tax cuts to large corporations, this may give more short-term growth to larger businesses, thus they will hire new people, invest more, etc. This could also lead to bigger paychecks to the top, as well as more room for companies to buy their own stock, which they will likely cause the stock price to go even further up for the short run.

 

If my theory is true that different factors are preventing the stock market from having a correction when it should, and it keeps on going up and up, This will be a devastating shock to the economy when it crashes. Considering big businesses take up a large portion of our economy, and since they are able to hire people, and expand out largely due to their market capitalization growing, if the market capitalization takes a big cut for many businesses, that isn’t good.

I have a theory that the bigger the drop in the stock market during a recession, the more dramatic it is for businesses, causing many to be laid off, many businesses to stop growing, etc. If it’s a much larger then normal bubble then in most recessions, then I sure hope we are all prepared. Don’t forget many baby boomers are retiring, and so now is a bad time to have a huge market crash. Also during a recession, people tend to consume less, so that hurts businesses even further.

Yours truly, from a 17-year-old arm-chaired economist! 🙂

 

 

My Bipartisan Ideas for Our Economy…

We need to grow our U.S economy through creative, bipartisan ideas. Here are a couple of examples!

 

Its very unfortunate to see the United States so divided. The statistics show that there is a continues progression with both parties becoming more and more divided and separate from each-other. It seems to have become an ‘Us verses them” mentality. As a teenager, I want to see our country become closer together, not farther apart. Though I clearly have my viewpoints as a democrat, I do believe that we are all Americans, and that despite the different viewpoints among-st the different parties, they both have good ideas. Besides, there isn’t enough ideas being considered that includes both sides ideas.

For example, considering an idea with how we can deal with the national debt, while increasing public assistance funding, since they are both important. Again both sides have important points we should all consider, even though I don’t agree with all of them! Not everything is black and white, and we want laws to last for the long term, not just be repealed every time someone new is elected. Below I have come up with some bipartisan ideas that both republicans and democrats can hopefully consider, and maybe one day use to benefit our economy for the better, and help my generations future!

 

FIRST IDEA: Decreasing the corporate tax rate, while closing up their tax loopholes.

The US has the highest corporate tax rate among-st developed nations, but many large corporations aren’t paying enough through dedications and loopholes. Some monopolies aren’t even paying anything at all! This is a problem overall for our economy, and for both parties. Its unfair that some corporations may pay a descent amount, while others can get away with paying virtually nothing, because of shipping their money somewhere outside of the country! How would you like to be the corporation that is paying its fair share, while your revile is paying nothing? Though there should be some flexibility on the tax, such as a companies size, revenue, etc, there should be a more solid tax that all corporations pay, (especially monopolies), period! However, in order to do this, we should also decreasing the corporate tax a bit as a compromise. Just because the corporate tax rate is very high, doesn’t necessary make them pay more, in fact, increasing it even farther may just worsen things. So to simplify, end corporate tax loopholes such as shipping money to some island to avoid taxes, unnecessary deductions, etc. But at the same time, compromise by decreasing the overall cooperate tax rate, but still make all of this apply to all corporations. We can all agree the tax code needs to be simplified to some extent.

 

SECOND IDEA: Gradually increase the Federal minimum wage from $7.25 to $15 an hour, but also make tax cuts to small businesses to make up for the change.

For the Americans whom make, or make close to the Federal minimum wage of just 7.25 an hour, it is very difficult to live off of that. There are many studies that claim its not even enough to support yourself on such a small wage, especially if you are supporting kids/ a spouse. However, it is true that an increase in minimum wage could hit small businesses hard, considering that we need the businesses to stay profitable, and want to hire workers. Plus, it wouldent be fair considering the idea that some small businesses are barely making enough in money, for themselves. What I suggest we should do is increase the minimum wage 7-10 percent a year, and for a long enough time until it reaches $15 an hour. However, this should occur while we at the same time with lowering taxes for small businesses. There should be a strong coloration between the raising of the minimum wage, and the amount deducted/ lowered for small businesses. This could all be a win-win situation, getting people out of poverty to live better lives, pay more in taxes etc. While at the same time, small businesses are able to afford to do this, and maybe even have more productive and happier workers.