Long Swings with Memory and Stock Market Fluctuations

It is now widely held that stock prices are too volatile to be optimal forecasts of future dividends discounted at a constant rate. Using the present value model with a constant discount rate, we show that when there is memory in the duration of dividend swings, the stock price can move in a more volatile fashion than could be warranted by future dividend movements. The memory in the duration of a dividend swing will lead economic agents to time the swing, thereby generating a spurious bias in the stock price. When memory is strong, this spurious bias becomes significant and induces excess volatility in the stock price as if rational bubbles exist. The Efficient Method of Moments (EMM) procedure is used to examine the long swings property in the dividend series. We cannot reject the hypothesis of a strong memory in the dividend swings, and show that excess volatility, even in large samples, can be generated through simulation.