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.

 

Why As a Teenager, Am I Concerned About Our U.S Economy… And Why You Should Be Too!

Even though many are still optimistic about the future of our U.S economy, don’t be optimistic just yet, or not welling to make change!

 

I am a teenage boy, just at the ripe age of 16 (soon to be 17.) People might wonder why I would be interested in such a subject, especially considering the fact that I am part of a such a young group and a supposedly ‘care free’ group. Not only is it an interest of mine, which I have even just finished my first draft on an economics book that I am writing, I also am simply anxious about how things are. I’m not just typically anxious about how the economy will be in the days, months, or years to come. I am worried about how it will come for my generation.
You often hear in times like this about how everything is going well. The unemployment is quite low, wages are going up, and we are successfully getting out of the 2008 recession. The stock market continues to go up, and overall, at least a portion of the population is content with how things are. Welcome to the economic cycle, the economic booms and busts, goes up, then comes down. Throughout history, especially recently there has been a lot of corruption that has led to downfalls and recessions in our economy. Though different people with different points of view will have a variety of explanations and claims for what is causing these downfalls in our economy, I see it as a lot of greed and misunderstanding. Many will agree that corruption going on in wall street was a big cause of the last recession, and I am among that group that thinks so.

Inequality continues to soar, while the middle class is stagnate, along with the majority of the population, even for some likely going down! Just looking at the charts, the top 1 percent has skyrocket over the past few decades, while little growth for most people has continued to happen. Also, power and greed continues to occur with places like the big banks, and certain monopolies continuing to lobby and hold special interest groups that has a strong say in our politics, and even amongst our politicians. Don’t get me wrong, I’m not against all monopolies, banks, and even wealth in general, but I don’t agree with record high inequality and lack of say and power amongst the middle class, while the top continues to profit. Problems continue to occur for the middle class, like a lack of a good health care system (which is about to change in a worse way, with millions losing their coverage as I speak.) Also, problems like college tuition continuing to beat inflation, and becoming unaffordable for many, especially for people with lower incomes.

So how does this all come of concern to a 16-year-old high schooler like me, and for many others in my age group, (or younger?) Well… for one, our society could continue to get worse inequality. Again, I’m not against some inequality, which is essential for a function-able society and for people to be motivated to work hard. I just don’t see our society with extreme inequality being good for anyone, even for the wealthy, without a strong middle class. Rather than looking at the trickle-down theory that many people started to believe in, especially since the Reagan area, why don’t we instead look at possible a ‘trickle up theory.’

As I get older, I want to see an educated middle class, where every teenager and child has the right to have a future and a good education, without a boatload of student loan debt. I believe that with more consumerism, and opportunity for the middle class to be more productive, and even more startups and entrepreneurs, we can have a better society and standard of living for everyone. Things aren’t all bad though, the standard of living has gotten much higher, even for the world over the many decades. The question is though, can it continue to get even better, especially for everyone? It is a concern that our GDP for last year was only 1.6% last year. I think everyone can agree on that. The question is, how can we make a society that benefits everyone, and use the best of our scarce resources? That’s what economics is all about.
As I spend more time on my blog I will talk more about how we can fix these problems, at least from my point of view. I am not expert or economist by any means, I’m just a 16-year-old boy, (who you could argue is kind of liberal!) However, I am anxious about the mentality and the statistics, and where we are heading. I think we can accomplish many things if we all work together and really look at the numbers, and have a good fundamental understanding of economics. Everyone, especially people my age should be more educated with economics, and other relating subjects like personal finance, now more than other. We can make change happen, and have our voices, (and hopefully my voice too), heard!!!

May I Suggest a New Tax Plan?

 What if rather than focusing on more or less taxation overall in our U.S economy, instead we have an alternative tax plan with a bit of both?….

 

As I have mentioned in one of my previous articles, there are many problems with our current United States economy. That article also mentioned how our economy may not be heading in the best direction, in the near and distant future. I mentioned all the problems, ranging from the massive inequality, to the corruption and greed going on, as well as an assortment of other problems, other than a few positives like a long-term upwards trend on standard of living. I believe that a major potential fix for our economy could potentially be an alternative tax system, unlike the majority of tax plans of many other countries throughout the world.
I think both Conservatives and Liberals alike can agree that Republicans overall want a decrease in taxation, and Democrats want an overall increase in taxation on everyone. That is a major problem. Both have pro’s and con’s, but it shouldn’t just be fully one or the other.
With a decrease in taxes, though you could potentially get more consumerism, and (with assuming a decrease on everyone’s taxes including the middle class), you could get a middle class that could potentially be able to save more, send their kids to college, etc. On the other hand, the government would have less money to spend that would benefit different groups of people such as the middle class and poor with welfare, public assistance, cheaper tuition, etc. In the United States, the percentage of the GDP being from the government is already very low compared to other countries, particularly in Europe.

Now with an overall in increase in taxes, you could in return have a bigger government that could make our society better with infrastructure and better education, and many other things. It could even involve paying off more of the national debt. Also, a higher taxation on the wealthy could really help redistribute the wealth and fix the major problem of inequality. However, the downside is this could hurt some of those with lower to middle incomes, considering many are already just breaking even, and don’t have much money to consume. Though many could potentially get this back with a variety of government programs, whats the point if its already taken from their own paychecks? Also think of the costs of transitioning the money from those people to the government and back into government services.

What if rather than having a tax plan that heavily taxes more or less on everyone in general, we have one that is rather, really progressive, but with big cuts to taxes with the middle class, and virtually no taxes for the poor (or at least very little.)

In simple terms…. this would be something like a huge decrease in taxes for those in the lower income quartile. A good decrease for the middle class in taxes, as well as more tax deductions in general. Then about the same taxes for the upper-middle incomers. Finally, a big increase for upper-incomers, and a super tax increase for the super wealthy.

So why have a taxation plan so progressive yet with so much cuts for a good amount of the population? Well the top 1 percent of our countries wealth, as well as the top 5% own a tremendous portion of the country’s wealth. Basically, as you get to a higher and higher percentile in income, you end up owning more and more of a stake in the wealth distribution. If we focus just on taxing mostly from the wealthy, you may possibly end up with more taxes than before, despite big taxes from everyone else, this is simply because the small percentage of the population that holds the majority of the wealth, holds such a large amount of money that can be taxed and more evenly distributed! The tax cuts from the middle class and poor can be beneficial on the other hand to the wealthy, because of the more consumerism that will result in them being better off. This will really help more spending in our economy and better profits for businesses, which results in more money for the wealthy in a sense. Think of rather than a ‘trickledown theory’ a ‘trickle up theory!’

Below is a rough idea of what I would believe to be a good alternative tax system, rather than just an increase or decrease in taxes overall! I call it the ‘Dwyer Ideal Tax Bracket’, named after me. (Something to keep in mind though, this is what I think each incomer should be taxed at, at the end of the day, not at what each dollar at each income bracket should be taxed at, like in the actual tax plan. However I do believe it should continue to be taxed on per dollar, rather than instantly change on each income amount.)

Capture taxThis is certainly quite different then our current tax plan and many tax plans throughout the world, especially considering how progressive it is. Though this might sound like a good plan, it is yet another problem to close up the loopholes in the first place that many of the ultra-wealthy take advantage of! If you are interested in reading more about my idea’s behind this tax system, as well as other economic insights in general from a teenager, read more from my blog, or wait for the book that I am close to finish writing to come out. It is about growing our economy! Stay put!…