Asset Pricing and the One Percent

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 5.6%. This negative relation remains strong and significant even when controlling for classic return predictors such as the price-dividend and the consumption-wealth ratios. To explain this stylized fact, we build a general equilibrium asset pricing model with heterogeneity in wealth and risk aversion across agents. Our model admits a testable moment condition and a novel two factor covariance pricing formula, where one factor is inequality. Intuitively, when wealth shifts into the hands of rich and risk tolerant agents, average risk aversion falls, pushing down the risk premium. Our model is broadly consistent with data and provides a novel positive explanation of both market excess returns over time and the cross section of returns across stocks.