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Sunday, July 19, 2009

"Garbage Research" and The Equity Risk Premium

Instead of the CCAPM (Consumption CAPM), we now have the GCAPM (Garbage CAPM). Alexi Savov (graduate student at U of Chicago) finds that he can explain much more of the Equity Risk Premium using aggregate garbage production than he can using National Income and Product Account (NIPA) data. Here's the logic behind his research (from Friday's Wall Street Journal article titled "Using Garbage to Measure Consumption"):
In theory, one way to explain the premium would be to look at consumption, a broad measure of wealth. People should demand a premium from an investment that goes down when consumption goes down. That’s because the alternative — bonds — hold on to their value when consumption declines. Another way to put it: When you are making lots of garbage, you are rich. When you stop making garbage, you are poor. Unlike bonds, which continue to pay out whether you produce lots of garbage (and are rich) or not, stocks are likely to lose their value during bad times. Therefore, investors should want a large reward for putting their money in something whose value decreases at the same time as their overall wealth decreases.
Unfortunately, the data typically used to measure consumption (the US Government's figures for personal expenditure on nondurable goods and services category in the National Income and Product Account) don't have a lot of variation. So, they don't work very well as an explanatory variable. Savov finds that whe he uses EPA records on aggregate garbage production, they're exhibit a correlation with equity returns that are twice as high as the NIPA/Equity returs correlations. Here's the abstract of his paper (downloadable from the SSRN):
A new measure of consumption -- garbage -- is more volatile and more correlated with stocks than the standard measure, NIPA consumption expenditure. A garbage-based CCAPM matches the U.S. equity premium with relative risk aversion of 17 versus 81 and evades the joint equity premium-risk-free rate puzzle. These results carry through to European data. In a cross section of size, value, and industry portfolios, garbage growth is priced and drives out NIPA expenditure growth.
Read the whole thing here.

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