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

  • Nathan S. Balke
  • Mark E. Wohar

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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