The Dividend Ratio Model

The equivalent risk-neutral valuation implies, that investors should not expect to earn more than a normal return in the stock market. We assess this prediction with a static regression framework, using stock market data for the five largest Euro area economies. In order to account for unobserved heterogeneity, we employ either first differences and orthogonal deviations transformations or an error components approach to estimation. While the dividend growth rate does not have explanatory power, the log dividend/price ratio is positively and significantly correlated to subsequent real gross return rates and its estimated coefficient increases linearly with the forecasting horizon. Following a behavioural interpretation these outcomes show asset prices are not correctly valued, because according to the efficient markets hypothesis the log dividend/price ratio should anticipate future dividend growth rates, rather than subsequent returns. Cognitive science suggests, that rational agents form expectations on the basis of heuristic rules to make financial decisions. Representativeness, availabilityAvailability and anchoringAnchoring may result in either under- or overvaluation of existing assets. An important aspect of the process of expectations formation is related to the application of Bayes’ rule.