How changes in income inequality can help us understand the pricing of financial assets

Understanding changes in the prices of stocks, bonds, and other financial instruments is at the very heart of financial economics. Yet asset pricing theory, as this area of research is known, has value outside of high finance as the research is trying to understand how people perceive risk. Turns out, income inequality explains a lot about how different investors on the income ladder perceive risk and react to it.

Existing research finds that the swings in asset prices are mostly due not to changes in payments from assets but rather due to changes in investors’ perceptions of risks in the future. Pinning down why those perceptions change is a major focus for the field. A new paper from the National Bureau of Economic Research shows that changes in inequality, particularly the share of income going to labor or capita can help explain fluctuations in stock prices.

The paper by economists Martin Lettau of the University of California-Berkeley’s Haas School of Business and Sydney C. Ludvigson and Sai Ma, both of New York University, looks at one specific question in asset pricing—the puzzle presented by the success of two very different investment strategies known as value investing and momentum investing. Value investing is what it sounds like, and is when the investor holds onto an asset for a while expecting its price to rise over time. Momentum investors try to get returns by purchasing assets that have done well recently or betting against those that are doing poorly. In other words, they are hoping the momentum of the asset will continue.

How can both investment strategies provide strong returns for investors? Well, the three researchers find that the correlation between the returns are negative. When one strategy does well, the other does poorly. The researchers then seek an answer to a second question: What kinds of investors would result in both of these strategies doing well but at different times?

Lettau, Ludvigson, and Ma show that including changes in the capital share in an accepted asset pricing model goes a long way to explaining this phenomenon. This change in the broader economy has an effect on the valuation of stocks. Their model explains between 85 to 95 percent of variation in average returns for portfolios.

When investors deploy rising capital income toward stocks, investment portfolios using the value strategy do well. But when the share income going to capital in the economy decreases, then momentum portfolios do well.

Why does this happen?

The paper’s argument is that changes in the capital share of the economy have different effects depending on where the stockholder is on the spectrum. Investors at the top of income distribution receive most, if not all of the gains, from an increase in the share of income going to capital. And investors lower down the stock-owning distribution see a reduction in earnings when total income shifts away from wages, where most of their income comes from, and toward capital—of which they have relatively less.

Putting together these findings, Lettau, Ludvigson, and Ma argue that most investors in the top 10 percent of the stockholding distribution are value investors while those in the bottom 90 percent are mostly momentum investors. The exact reason why those at the top invest differently than the rest of the population is not fully understood and more research is needed. But this paper highlights how changes in inequality affect perceptions of risk and therefore the value of financial assets.