The Response of Stock Prices to Permanent and Temporary Shocks to Dividends

This paper investigates the response of stock prices to dividend shocks in a bivariate model of stock prices and price-dividend spreads. Dividend process is modeled as the sum of a permanent component and a temporary component. By using the stock price valuation (present value) model, the two components are related to stock prices. The stock market responds significantly not only to permanent shocks to dividends, but also to temporary shocks to dividends. Furthermore, initial responses of stock prices to the temporary shocks are as strong as those to the permanent shocks. As a result, substantial variation in stock prices is due to the temporary shocks. This finding provides empirical support for the imperfect information hypothesis that emphasizes the failure of investors to clearly distinguish between the two components of dividends, and also suggests that the observed mean-reverting behavior of stock returns should be explained by incorporating a significant temporary component into stockprices. The price-dividend spreads are primarily accounted for by the temporary shocks to dividends, and respond strongly to them, suggesting that, in response to the temporary shocks to dividends, stock prices respond excessively relative to dividends.