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

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Author Info
Nathan S. Balke
Mark E. Wohar

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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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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;

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  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, 06. [Downloadable!] (restricted)
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  2. Ravi Jagannathan & Ellen R. McGrattan & Anna Scherbina., 2000. "The declining U.S. equity premium," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 3-19. [Downloadable!]
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  3. Ellen R. McGrattan & Edward C. Prescott, 2000. "Is the stock market overvalued?," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 20-40. [Downloadable!]
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  4. 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.). [Downloadable!]
  5. 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. [Downloadable!] (restricted)
  6. John H. Cochrane, 1997. "Where is the market going? Uncertain facts and novel theories," Economic Perspectives, Federal Reserve Bank of Chicago, issue Nov, pages 3-37. [Downloadable!]
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  7. 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. [Downloadable!]
  8. Richard W. Kopcke, 1997. "Are stocks overvalued?," New England Economic Review, Federal Reserve Bank of Boston, issue Sep, pages 21-40. [Downloadable!]
  9. Olivier J. Blanchard, 1993. "Movements in the Equity Premium," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 24(1993-2), pages 75-138. [Downloadable!]
  10. 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.
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  11. Campbell, John Y & Ammer, John, 1993. " What Moves the Stock and Bond Markets? A Variance Decomposition for Long-Term Asset Returns," Journal of Finance, American Finance Association, vol. 48(1), pages 3-37, March. [Downloadable!] (restricted)
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  12. 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. [Downloadable!] (restricted)
  13. Shiller, Robert J, 1981. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," American Economic Review, American Economic Association, vol. 71(3), pages 421-36, June. [Downloadable!] (restricted)
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  14. 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. [Downloadable!] (restricted)
  15. Bart Hobijn & Boyan Jovanovic, 2000. "The Information Technology Revolution and the Stock Market: Evidence," NBER Working Papers 7684, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  16. John B. Carlson & Eduard A. Pelz, 2000. "Investor expectations and fundamentals: disappointment ahead?," Economic Commentary, Federal Reserve Bank of Cleveland, issue May 1. [Downloadable!]
  17. Barsky, Robert B. & Long, J. Bradford De, 1990. "Bull and Bear Markets in the Twentieth Century," The Journal of Economic History, Cambridge University Press, vol. 50(02), pages 265-281, June. [Downloadable!]
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Robert Sollis, 2006. "Testing for bubbles: an application of tests for change in persistence," Applied Financial Economics, Taylor and Francis Journals, vol. 16(6), pages 491-498, March. [Downloadable!] (restricted)
  2. Brendan McCabe & Stephen Leybourne & David Harris, 2003. "Testing for Stochastic Cointegration and Evidence for Present Value Models," Econometrics 0311009, EconWPA. [Downloadable!]
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