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Stock Prices, Earnings and Expected Dividends

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Abstract

This paper presents estimates indicating that, for aggregate U.S. stock market data 1871-1986, a long historical average of real earnings is a good predictor of the present value of future real dividends. This is true even when the information contained in stock prices is taken into account. We estimate that for each year the optimal forecast of the present value of future real dividends is roughly a weighted average of moving average earnings and current real price, with between 2/3 and 3/4 of the weight on the earnings measure. This means that simple present value models of stock market prices can be strongly rejected. We use a vector autoregressive approach which enables us to compute the implications of this for the behavior of stock prices and returns. We estimate that log dividend-price ratios are more variable than, and virtually uncorrelated with, their theoretical counterparts given the present value models. Annual returns on stocks are quite highly correlated with their theoretical counterparts, but are two to four times as variable. Our approach also reveals the connection between recent papers showing forecastability of long-horizon returns on corporate stocks, and earlier literature claiming that stock prices are too volatile to be accounted for in terms of simple present value models. We show that excess volatility directly implies the forecastability of long-horizon returns.

Suggested Citation

  • John Y. Campbell & Robert J. Shiller, 1988. "Stock Prices, Earnings and Expected Dividends," Cowles Foundation Discussion Papers 858, Cowles Foundation for Research in Economics, Yale University.
  • Handle: RePEc:cwl:cwldpp:858
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    1. Summers, Lawrence H, 1986. " Does the Stock Market Rationally Reflect Fundamental Values?," Journal of Finance, American Finance Association, vol. 41(3), pages 591-601, July.
    2. Kormendi, Roger & Lipe, Robert, 1987. "Earnings Innovations, Earnings Persistence, and Stock Returns," The Journal of Business, University of Chicago Press, vol. 60(3), pages 323-345, July.
    3. Mankiw, N Gregory & Romer, David & Shapiro, Matthew D, 1985. " An Unbiased Reexamination of Stock Market Volatility," Journal of Finance, American Finance Association, vol. 40(3), pages 677-687, July.
    4. West, Kenneth D, 1988. "Dividend Innovations and Stock Price Volatility," Econometrica, Econometric Society, vol. 56(1), pages 37-61, January.
    5. Campbell, John Y & Shiller, Robert J, 1987. "Cointegration and Tests of Present Value Models," Journal of Political Economy, University of Chicago Press, vol. 95(5), pages 1062-1088, October.
    6. Robert J. Shiller, 1984. "Stock Prices and Social Dynamics," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 15(2), pages 457-510.
    7. De Bondt, Werner F M & Thaler, Richard, 1985. " Does the Stock Market Overreact?," Journal of Finance, American Finance Association, vol. 40(3), pages 793-805, July.
    8. Marsh, Terry A & Merton, Robert C, 1986. "Dividend Variability and Variance Bounds Tests for the Rationality ofStock Market Prices," American Economic Review, American Economic Association, vol. 76(3), pages 483-498, June.
    9. Marsh, Terry A & Merton, Robert C, 1987. "Dividend Behavior for the Aggregate Stock Market," The Journal of Business, University of Chicago Press, vol. 60(1), pages 1-40, January.
    10. John Y. Campbell, Robert J. Shiller, 1988. "The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors," Review of Financial Studies, Society for Financial Studies, vol. 1(3), pages 195-228.
    11. Shiller, Robert J, 1981. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," American Economic Review, American Economic Association, vol. 71(3), pages 421-436, June.
    12. Kleidon, Allan W, 1986. "Variance Bounds Tests and Stock Price Valuation Models," Journal of Political Economy, University of Chicago Press, vol. 94(5), pages 953-1001, October.
    13. Poterba, James M. & Summers, Lawrence H., 1988. "Mean reversion in stock prices : Evidence and Implications," Journal of Financial Economics, Elsevier, vol. 22(1), pages 27-59, October.
    14. Gregory, Allan W & Veall, Michael R, 1985. "Formulating Wald Tests of Nonlinear Restrictions," Econometrica, Econometric Society, vol. 53(6), pages 1465-1468, November.
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    Keywords

    Stock market; dividends; stock prices; volatility;

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