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Explaining stock price movements: is there a case for fundamentals?

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  • Nathan S. Balke
  • Mark E. Wohar

Abstract

Some observers have argued that the run-up in the Standard & Poor's 500 stock price index during the 1990s was due to irrational exuberance rather than market fundamentals. This article presents evidence that the case for market fundamentals is stronger than it appears on the surface. Nathan Balke and Mark Wohar show that movements in the price-dividend and price-earnings rations have exhibited substantial persistence, particularly since World War II. Hence, using the long-run historical average value of the price/earnings or price/dividend ratio as the "normal" valuation ratio is misleading. The authors also show that plausible combinations of lower expected future real discount rates and higher expected real dividend (earnings) growth could rationalize current broad market stock values, raising the possibility that changes in market fundamentals have made a major contribution to the run-up in stock prices. Even if market fundamentals were responsible for the increase in stock prices during the 1990s, we should not necessarily expect future stock returns to be as high as the returns seen in the latter half of the 1990s.

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Bibliographic Info

Article provided by Federal Reserve Bank of Dallas in its journal Economic and Financial Policy Review.

Volume (Year): (2001)
Issue (Month): Q III ()
Pages: 22-34

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Handle: RePEc:fip:fedder:y:2001:i:qiii:p:22-34

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Keywords: Stock - Prices ; Stock market;

References

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  1. Nathan S. Balke & Mark E. Wohar, 2002. "Low-Frequency Movements in Stock Prices: A State-Space Decomposition," The Review of Economics and Statistics, MIT Press, vol. 84(4), pages 649-667, November.
  2. Ellen R. McGrattan & Edward C. Prescott, 2001. "Is the Stock Market Overvalued?," NBER Working Papers 8077, National Bureau of Economic Research, Inc.
  3. Richard W. Kopcke, 1997. "Are stocks overvalued?," New England Economic Review, Federal Reserve Bank of Boston, issue Sep, pages 21-40.
  4. John H. Cochrane, 1998. "Where is the Market Going? Uncertain Facts and Novel Theories," NBER Working Papers 6207, National Bureau of Economic Research, Inc.
  5. John Y. Campbell & John H. Cochrane, 1995. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," NBER Working Papers 4995, National Bureau of Economic Research, Inc.
  6. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April.
  7. Schwert, G. William, 1987. "Effects of model specification on tests for unit roots in macroeconomic data," Journal of Monetary Economics, Elsevier, vol. 20(1), pages 73-103, July.
  8. Steven A. Sharpe, 1999. "Stock prices, expected returns, and inflation," Finance and Economics Discussion Series 1999-02, Board of Governors of the Federal Reserve System (U.S.).
  9. Bart Hobijn & Boyan Jovanovic, 2001. "The Information-Technology Revolution and the Stock Market: Evidence," American Economic Review, American Economic Association, vol. 91(5), pages 1203-1220, December.
  10. Campbell, J.Y. & Ammer, J., 1991. "What Moves The Stock And Bond Markets? A Variance Decomposition For Long- Term Asset Returns," Papers 127, Princeton, Department of Economics - Financial Research Center.
  11. John B. Carlson & Eduard A. Pelz, 2000. "Investor expectations and fundamentals: disappointment ahead?," Economic Commentary, Federal Reserve Bank of Cleveland, issue May.
  12. John B. Carlson, 1999. "The recent ascent in stock prices: how exuberant are you?," The Region, Federal Reserve Bank of Minneapolis, issue Dec, pages 8-11, 47.
  13. Harrison Hong & Jeremy C. Stein, 1999. "A Unified Theory of Underreaction, Momentum Trading, and Overreaction in Asset Markets," Journal of Finance, American Finance Association, vol. 54(6), pages 2143-2184, December.
  14. Ravi Jagannathan & Ellen R. McGrattan & Anna Scherbina, 2001. "The Declining U.S. Equity Premium," NBER Working Papers 8172, National Bureau of Economic Research, Inc.
  15. John B. Carlson & Kevin H. Sargent, 1997. "The recent ascent of stock prices: can it be explained by earnings growth or other fundamentals?," Economic Review, Federal Reserve Bank of Cleveland, issue Q II, pages 2-12.
  16. Olivier J. Blanchard, 1993. "Movements in the Equity Premium," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 24(2), pages 75-138.
  17. Olivier J. Blanchard & Lawrence H. Summers, 1984. "Perspectives on High World Real Interest Rates," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 15(2), pages 273-334.
  18. Robert J. Shiller, 1980. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," NBER Working Papers 0456, National Bureau of Economic Research, Inc.
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Citations

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Cited by:
  1. Filis, George, 2010. "Macro economy, stock market and oil prices: Do meaningful relationships exist among their cyclical fluctuations?," Energy Economics, Elsevier, vol. 32(4), pages 877-886, July.
  2. Taipalus, Katja, 2012. "Detecting asset price bubbles with time-series methods," Scientific Monographs E:47/2012, Bank of Finland.
  3. McMillan, David G., 2006. "The price-dividend ratio and limits to arbitrage: Evidence from a time-varying ESTR model," Economics Letters, Elsevier, vol. 91(3), pages 408-412, June.
  4. McMillan, David G., 2007. "Bubbles in the dividend-price ratio? Evidence from an asymmetric exponential smooth-transition model," Journal of Banking & Finance, Elsevier, vol. 31(3), pages 787-804, March.
  5. Woglom, Geoffrey, 2003. "Endowment spending rates, intergenerational equity and the sources of capital gains," Economics of Education Review, Elsevier, vol. 22(6), pages 591-601, December.
  6. Brendan McCabe & Stephen Leybourne & David Harris, 2003. "Testing for Stochastic Cointegration and Evidence for Present Value Models," Econometrics 0311009, EconWPA.
  7. David G. McMillan, 2010. "Level-shifts and non-linearity in US financial ratios: Implications for returns predictability and the present value model," Review of Accounting and Finance, Emerald Group Publishing, vol. 9(2), pages 189-207, May.
  8. McMillan, David G., 2009. "Are share prices still too high?," Research in International Business and Finance, Elsevier, vol. 23(3), pages 223-232, September.
  9. Binswanger, Mathias, 2004. "Stock returns and real activity in the G-7 countries: did the relationship change during the 1980s?," The Quarterly Review of Economics and Finance, Elsevier, vol. 44(2), pages 237-252, May.

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