Abstract
We show that in a general equilibrium model with heterogeneity in risk aversion or belief, shifting wealth from an agent who holds comparatively fewer stocks to one who holds more reduces the equity premium. Since empirically the rich hold more stocks than do the poor, the top income share should predict subsequent excess stock market returns. Consistent with our theory, we find that when the income share of the top 1% income earners in the U.S. rises above trend by one percentage point, subsequent one year market excess returns decline on average by about 3-5%. This negative relation is robust to (i) controlling for classic return predictors such as the price-dividend and consumption-wealth ratios and (ii) predicting out-of-sample. Cross-country panel regressions suggest that the inverse relation between inequality and returns also holds outside of the U.S., with stronger results in relatively closed economies (emerging markets) than in small open economies (Europe).
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