Abstract
This paper seeks to model the adjustment process in the stock market by a continuous time state space model focusing on input-out relations. The value of the S&P 500 is generated as the output of the model with earnings and the interest rate as input. The model is found to fit the data well, and indicates that the stock price dynamics can be considered as a price-following-value process. The value determines the time varying trend of price, and random buy-sell pressure drives price fluctuations about value. The 1987 stock price bubble shows up clearly as a gap between price and value.
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