What explains the difference in returns between stocks and bonds?
One theory is that the difference in returns is due to the safety of bonds when consumption declines (the so called ‘risk premium‘ is built into stock returns). One of the issues with testing this hypothesis is that the most commonly quoted measure of consumption, the National Income and Product Account, is too nonvolatile to explain the risk premium on its own. Alexi Savov, a grad-student at Chicago, has produced a fascinating look at using residential garbage production in order to take a closer look at the correlation between stock returns and consumption.
Garbage In, Garbage Out
Risk is the main reason that different classes of securities have different returns. Savov uses T-Bills, short term government issued securities, as a proxy for a ‘risk-free‘ security. Obviously nothing is 100% risk free. In the world of finance, debt issued from the US government is still the gold standard (I say that with full irony) and about as close to risk free as any investment can be.
Using EPA reported numbers on the amount of waste generated by households, (and eliminating lawn clippings, for reasons described in the paper) Alexi shows a 58% correlation between stock returns and waste generation in America. He runs his methodology on data for other countries, including 19 countries in Europe. Not every country has such a high correlation between their stock market returns and garbage output (Luxembourg is -.07, Denmark is .00, for example), but some countries correlate quite closely. Japan’s correlation, for example, is .90. Savov also correlates NIPA reported expenditures for his various country studies, which can be seen in table VII of his paper.
Like Yesterday’s Garbage
How can you take advantage of this phenomenon? As a post in the Wall Street Journal notes, not by using garbage amount reports to plan stock investments- garbage production is a symptom of consumption, so it will be too late for actionable ideas once the garbage is reported. That rules out searching through your neighbor’s garbage before logging onto E*Trade. However, this research is nonetheless a good read and pretty mind-expanding. Have you seen other creative studies like this you’d care to share? Hit me with some in the comments.