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The Stock Market and the Corporate Sector: A Profit-Based Approach

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  • Anwar M. Shaikh

    (The Jerome Levy Economics Institute)

Abstract

This paper shows that the empirical movements of stock prices can be explained directly by fundamentals. The real stock market rate of return is shown to closely track the real incremental rate of profit of the corporate sector, with the two rates displaying similar means and standard deviations. It is argued that the two are linked by capital flows between the sectors through a process we call "turbulent arbitrage". Actual equity prices closely track the prices closely track the prices warranted by this model, and unlike the standard results, are less volatile than the warranted ones. The theoretical approach taken in this paper implies that the incremental profit rate is the required rate of return for the stock market return. The observed volatility on stock market returns and prices arises from the fact that the required rate is itself highly volatile, driven by cyclical and other short term fluctuations in aggregate demand. It is then easy to see why conventional theoretical models, which typically assume constant required rates of return (discount rates) and constant dividend growth rates, are largely unable to explain the movements in stock prices. On the other hand, since the incremental rate of profit (net of interest) is essentially the change in earnings normalized by investment, the findings of this paper accord well the experience "on the street" that stock price movements are driven by interest rates and changes in earnings.

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File URL: http://128.118.178.162/eps/mac/papers/9811/9811007.pdf
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Bibliographic Info

Paper provided by EconWPA in its series Macroeconomics with number 9811007.

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Length: 16 pages
Date of creation: 19 Nov 1998
Date of revision:
Handle: RePEc:wpa:wuwpma:9811007

Note: Type of Document - Acrobat PDF; prepared on IBM PC; to print on PostScript; pages: 16; figures: included
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Web page: http://128.118.178.162

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  1. Robert J. Shiller, 1989. "Comovements in Stock Prices and Comovements in Dividends," NBER Working Papers 2846, National Bureau of Economic Research, Inc.
  2. John Y. Campbell, 1990. "A Variance Decomposition for Stock Returns," NBER Working Papers 3246, National Bureau of Economic Research, Inc.
  3. Campbell, John Y, 1990. "Measuring the Persistence of Expected Returns," American Economic Review, American Economic Association, vol. 80(2), pages 43-47, May.
  4. J. Bradford De Long & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, . "Noise Trader Risk in Financial Markets," J. Bradford De Long's Working Papers _124, University of California at Berkeley, Economics Department.
  5. Cutler, David M & Poterba, James M & Summers, Lawrence H, 1990. "Speculative Dynamics and the Role of Feedback Traders," American Economic Review, American Economic Association, vol. 80(2), pages 63-68, May.
  6. Fama, Eugene F, 1991. " Efficient Capital Markets: II," Journal of Finance, American Finance Association, vol. 46(5), pages 1575-617, December.
  7. Barsky, Robert B & De Long, J Bradford, 1993. "Why Does the Stock Market Fluctuate?," The Quarterly Journal of Economics, MIT Press, vol. 108(2), pages 291-311, May.
  8. Feldstein, Martin S & Rothschild, Michael, 1974. "Towards an Economic Theory of Replacement Investment," Econometrica, Econometric Society, vol. 42(3), pages 393-423, May.
  9. Fama, Eugene F & French, Kenneth R, 1988. "Permanent and Temporary Components of Stock Prices," Journal of Political Economy, University of Chicago Press, vol. 96(2), pages 246-73, April.
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Citations

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Cited by:
  1. Stravelakis, Nikos, 2013. "Hilferding over Marx: A Political Economy Viewpoint of Struggles in the Left 1900-1933 and the Modern Revival," MPRA Paper 50064, University Library of Munich, Germany.
  2. Anwar Shaikh, 2010. "Reflexivity, path dependence, and disequilibrium dynamics," Journal of Post Keynesian Economics, M.E. Sharpe, Inc., vol. 33(1), pages 3-16, October.
  3. Tsoulfidis, Lefteris, 2011. "Classical vs. Neoclassical Conceptions of Competition," MPRA Paper 43999, University Library of Munich, Germany, revised Oct 2012.
  4. Andrea Vaona, 2011. "Further econometric evidence on the gravitation and convergence of industrial rates of return on regulating capital," Working Papers 08/2011, University of Verona, Department of Economics.
  5. Andrea Vaona, 2010. "On the gravitation and convergence of industry incremental rates of return in OECD countries," Working Papers 03/2010, University of Verona, Department of Economics.
  6. Stefania Tescari & Andrea Vaona, 2013. "Regulating rates of return do gravitate in US manufacturing!," Working Papers 19/2013, University of Verona, Department of Economics.
  7. John Sarich, 2006. "What do we know about the real exchange rate? A classical cost of production story," Review of Political Economy, Taylor & Francis Journals, vol. 18(4), pages 469-496.
  8. Bilgili, Faik, 2003. "Dynamic implications of fiscal policy: Crowding-out or crowding-in?," MPRA Paper 24111, University Library of Munich, Germany, revised 25 Dec 2009.
  9. Lefteris Tsoulfidis & Persefoni Tsaliki, 2011. "Classical Competition and Regulating Capital: Theory and Empirical Evidence," Discussion Paper Series 2011_02, Department of Economics, University of Macedonia, revised Feb 2011.

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