Toward a Theory of Everything?

The article “Searching for the equity premium” (with Hang Bai) is now forthcoming at Journal of Financial Economics (paper, slides).

For its motivation and overview of key results, please see my last blog posted on 10/18/2020.

A surprising insight from our revision is the properties of investment and hiring returns. Despite a high average labor share in output calibrated to 74.6% (Gollin 2002), the capital share in the market equity is on average 92.6%! As such, even though labor market frictions play a central role in our search economy, the stock market is mostly for shareholders.

Panel A below shows the scatter-plot of the capital share in value against aggregate productivity in our economy. As in a Covid map, dark red means high density, and light green low density. The value-weight of capital exhibits countercyclical dynamics, approaching 100% in very bad times, meaning that the shadow value of labor goes to zero.

(In Panel B, the labor share in output is countercyclical, not surprisingly. Panel C shows an alternative labor share, in which wage equals the marginal product of labor, is weakly countercyclical, due to the CES production function.) 

The 92.6% estimate of the value-weight of capital has broad implications beyond this paper. In the cross section, the prior literature has mostly examined investment returns due to severe limitations of firm-level labor data. If we are right in that stock returns primarily consist of investment returns, prior cross-sectional results based on investment returns are likely to survive extensions to labor.

Finally, I wish to acknowledge a weakness of the model (see Section 4.5). It turns out the postwar US sample is not representative at all from the model's perspective. In 10,000+ simulations, we could not find a single path with the equity premium no lower than, but the consumption volatility no higher than that in the postwar US sample. I suspect that a similar problem might also be present in the Rietz-Barro exogenous disaster literature, although I have not seen an explicit discussion yet. So the search continues...