Abstract
We study fluctuations in stock prices using a framework derived from the present value model augmented with a macroeconomic factor. The fundamental value is derived as the expected present discounted value of broad dividends that include, in addition to traditional cash dividends, other payouts to shareholders. A stochastic discount factor motivated by the consumption-based asset pricing model is utilized. A single macroeconomic factor, namely the output gap determines the non-fundamental component of stock prices. A resulting trivariate Vector Autoregression (TVAR) model of stock prices, broad dividends, and the output gap shows evidence of cointegration in the DJIA and S&P 500 index data. Nonetheless, a sup augmented Dickey-Fuller test reveals existence of periodically collapsing bubbles in S&P 500 data during the late 1990s.
Highlights
Most research on understanding the behavior of stock prices is based on the present value model (PVM) or the more general consumption-based model
An augmented Dickey-Fuller (ADF) test is performed on stock prices Pt, broad dividends X t, and the output gap gt
A trivariate Vector Autoregression (VAR) (TVAR) model for stock prices, broad dividends, and the output gap is used to test for cointegration between these three variables with Johansen (1988)
Summary
Most research on understanding the behavior of stock prices is based on the present value model (PVM) or the more general consumption-based model. More precise measures of fundamentals such as broad dividends and net payouts in place of traditional cash dividends in the present value model, habit formation in consumption designed to add volatility to the stochastic discount factor in the consumption-based model to overcome smoothness in observed consumption, new utility functions such as Epstein-Zin (1989) recursive utility, heterogeneous agent models, irrational expectations on the part of investors, and bubbles have been proposed to resolve the discrepancy between the empirical implications of the two models and observed stock market data None of these explanations has been convincing enough to stop the search for alternative explanations for rationalizing movements in stock prices
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