Household Debt, Stock Market Participation, and Stock Market Returns: A Mediation Analysis

This thesis investigates whether increases in household debt increase stock market participation, and consequently decrease stock market returns. The three-way link is investigated across the immediate, short, and medium term, income groups, and the business cycle. Furthermore, the thesis investigates whether low interest rate environments lead to an increase in the relationship between household debt, stock market participation, and consequently stock market returns.

A three-step approach to Mediation Analysis using One-way Fixed Effect (“Within” Estimation) Regression is employed on an unbalanced panel of 14 advanced and 3 emerging market economies from 2001 to 2022. The results show that there is a negative association between household debt and stock market returns in the contemporaneous and short term, which is more pronounced in developing countries, during financial crisis periods, and in high interest rate environments. Furthermore, the negative association between household debt and stock market returns is confounded, not mediated, by stock market participation in the contemporaneous term only. The confounding effect does not vary across income groups, the business cycle, or the interest rate environment. The results are robust to using stock market development as the dependent variable.

The findings disprove existing theories that purport that household debt inflates asset prices (consequently lowering returns) initially, but stress selling (debt liquidation) then follows. This study recommends that devoting resources to tracking the use of household debt will prove an inefficient use of banks’ resources. Future studies could be extended by examining how household debt could be impacted by political and economic policy uncertainty.