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The Stock Market and the Corporate Sector: Profit-Based Approach

  • Anwar M. Shaikh

This paper shows that the empirical movements of stock prices can be explained directly by fundamentals. The real stock market rate of return is shown to closely track the real incremental rate of profit of the corporate sector, with the two rates displaying similar means and standard deviations. It is argued that the two are linked by capital flows between the sectors through a process we call "turbulent arbitrage". Actual equity prices closely track the prices closely track the prices warranted by this model, and unlike the standard results, are less volatile than the warranted ones. The theoretical approach taken in this paper implies that the incremental profit rate is the required rate of return for the stock market return. The observed volatility on stock market returns and prices arises from the fact that the required rate is itself highly volatile, driven by cyclical and other short term fluctuations in aggregate demand. It is then easy to see why conventional theoretical models, which typically assume constant required rates of return (discount rates) and constant dividend growth rates, are largely unable to explain the movements in stock prices. On the other hand, since the incremental rate of profit (net of interest) is essentially the change in earnings normalized by investment, the findings of this paper accord well the experience "on the street" that stock price movements are driven by interest rates and changes in earnings.

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Paper provided by Levy Economics Institute in its series Economics Working Paper Archive with number wp_146.

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Date of creation: Sep 1995
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Handle: RePEc:lev:wrkpap:wp_146
Contact details of provider: Web page: http://www.levyinstitute.org

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  1. Robert J. Shiller, 1989. "Comovements in Stock Prices and Comovements in Dividends," NBER Working Papers 2846, National Bureau of Economic Research, Inc.
  2. Campbell, John Y, 1991. "A Variance Decomposition for Stock Returns," Economic Journal, Royal Economic Society, vol. 101(405), pages 157-79, March.
  3. Cutler, David M & Poterba, James M & Summers, Lawrence H, 1990. "Speculative Dynamics and the Role of Feedback Traders," American Economic Review, American Economic Association, vol. 80(2), pages 63-68, May.
  4. Fama, Eugene F & French, Kenneth R, 1988. "Permanent and Temporary Components of Stock Prices," Journal of Political Economy, University of Chicago Press, vol. 96(2), pages 246-73, April.
  5. John Y. Campbell, 1990. "Measuring the Persistence of Expected Returns," NBER Working Papers 3305, National Bureau of Economic Research, Inc.
  6. Robert B. Barsky & J. Bradford De Long, 1992. "Why Does the Stock Market Fluctuate?," NBER Working Papers 3995, National Bureau of Economic Research, Inc.
  7. De Long, J Bradford & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1990. "Noise Trader Risk in Financial Markets," Journal of Political Economy, University of Chicago Press, vol. 98(4), pages 703-38, August.
  8. Feldstein, Martin S & Rothschild, Michael, 1974. "Towards an Economic Theory of Replacement Investment," Econometrica, Econometric Society, vol. 42(3), pages 393-423, May.
  9. Fama, Eugene F, 1991. " Efficient Capital Markets: II," Journal of Finance, American Finance Association, vol. 46(5), pages 1575-617, December.
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