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Stock Prices, Earnings And Expected Dividends

  • CAMPBELL, J.Y.
  • SHILLER, R.J.

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 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.

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Paper provided by Princeton, Department of Economics - Econometric Research Program in its series Papers with number 334.

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Length: 40 pages
Date of creation: 1988
Date of revision:
Handle: RePEc:fth:prinem:334
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  1. 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 421-36, June.
  2. Robert J. Shiller & John Y. Campbell, 1986. "The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors," Cowles Foundation Discussion Papers 812, Cowles Foundation for Research in Economics, Yale University.
  3. 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.
  4. Kenneth D. West, 1986. "Dividend Innovations and Stock Price Volatility," NBER Working Papers 1833, National Bureau of Economic Research, Inc.
  5. 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.
  6. Kormendi, Roger & Lipe, Robert, 1987. "Earnings Innovations, Earnings Persistence, and Stock Returns," The Journal of Business, University of Chicago Press, vol. 60(3), pages 323-45, July.
  7. 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.
  8. N. Gregory Mankiw & David Romer & Matthew D. Shapiro, 1985. "An Unbiased Reexamination of Stock Market Volatility," Cowles Foundation Discussion Papers 758, Cowles Foundation for Research in Economics, Yale University.
  9. 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.
  10. Marsh, Terry A. & Merton, Robert C., 1984. "Dividend variability and variance bounds tests for the rationality of stock market prices," Working papers 1584-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  11. John Y. Campbell & Robert J. Shiller, 1986. "Cointegration and Tests of Present Value Models," NBER Working Papers 1885, National Bureau of Economic Research, Inc.
  12. Gregory, Allan W & Veall, Michael R, 1985. "Formulating Wald Tests of Nonlinear Restrictions," Econometrica, Econometric Society, vol. 53(6), pages 1465-68, November.
  13. Robert J. Shiller, 1984. "Stock Prices and Social Dynamics," Cowles Foundation Discussion Papers 719R, Cowles Foundation for Research in Economics, Yale University.
  14. Terry A. Marsh and Robert C. Merton., 1986. "Dividend Behavior for the Aggregate Stock Market," Research Program in Finance Working Papers 163, University of California at Berkeley.
  15. 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.
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