The Stock Market and the Corporate Sector: A Profit-Based Approach
AbstractThis 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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Bibliographic InfoPaper provided by EconWPA in its series Macroeconomics with number 9811007.
Length: 16 pages
Date of creation: 19 Nov 1998
Date of revision:
Note: Type of Document - Acrobat PDF; prepared on IBM PC; to print on PostScript; pages: 16; figures: included
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Other versions of this item:
- Anwar M. Shaikh, 1995. "The Stock Market and the Corporate Sector: Profit-Based Approach," Economics Working Paper Archive wp_146, Levy Economics Institute.
- E - Macroeconomics and Monetary Economics
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