The predictive power of the present value model of stock prices
AbstractUsing monthly data from 1926:01 to 2003:12 for the United States, this paper examines the predictability of real stock prices based on the dividend-price ratio. In particular, we focus on estimating and forecasting a nonlinear exponential smooth autoregressive model (ESTAR). One motivation for nonlinearity in asset markets is the presence of transaction costs, which result in a nonlinear adjustment process towards equilibrium through arbitrage. Using a novel approach that allows for the joint testing of nonlinearity and nonstationarity, we are able to reject the null hypothesis of linearity and that of a nonlinear unit root. We also find evidence of a nonlinear cointegrating relationship between stock prices and dividends where the error correction term follows a globally stationary ESTAR process. This evidence together with nonlinear impulse response functions, which show that large deviations have faster speeds of mean reversion than small deviations indicates that while stock prices may reflect their fundamentals in the long run, they may deviate substantially from their fundamentals for periods of time. Using an ESTAR-EGARCH model of the dividend-price ratio we find empirical support for in-sample and out-of-sample long-horizon predictability, and we explain why it is often difficult to exploit this predictability using real-time forecasts.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by Society for Computational Economics in its series Computing in Economics and Finance 2006 with number 102.
Date of creation: 04 Jul 2006
Date of revision:
Present Value Model of Stock Prices; Nonlinear Unit Root Tests; Nonlinear Cointegration Tests; ESTAR- EGARCH model; Long Horizon Predictability Tests;
Find related papers by JEL classification:
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
- G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies
- C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
This paper has been announced in the following NEP Reports:
- NEP-ALL-2006-07-15 (All new papers)
- NEP-ECM-2006-07-15 (Econometrics)
- NEP-FIN-2006-07-15 (Finance)
- NEP-FMK-2006-07-15 (Financial Markets)
- NEP-FOR-2006-07-15 (Forecasting)
- NEP-RMG-2006-07-15 (Risk Management)
You can help add them by filling out this form.
reading list or among the top items on IDEAS.Access and download statisticsgeneral information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Christopher F. Baum).
If references are entirely missing, you can add them using this form.