Rationality of Deviations between Fundamental Valuations, and Market Valuations

Abstract

This study arrives at a well defined mapping for distinguishing of rational valuation bubbles from valuation bubbles that, asymptotically are irrational. In stated respect, the formal theory shows a ranking, in descending order, of publicly quoted firms with respect to intertemporal `dynamism' at management of asset risk maps to a ranking of same firms, in descending order, with respect to risk aversion coefficients of investor clienteles. Conformity, respectively, non-conformity to the mapping robustly evinces presence, respectively absence of rational valuation bubbles. In presence of non-spurious and economically significant realizations for idiosyncratic risk in real sectors - `revealed' non-dynamism at attenuation of asset risk to systemic risk - demand for risk seeking agents explicitly and endogenously is established to be a necessary condition for general equilibrium (risk aversion coefficients for risk seeking agents necessarily are lower than corresponding coefficients for risk averse agents). A novel general equilibrium result is formal theoretical evidence that risk seeking preferences necessarily embed loss aversion, with outcome `safer' estimates for conditional skewness strictly are preferred to `less safe' estimates for conditional skewness. Comparison of a ranking of fundamental valuations that are premised on dynamism of management of asset risk (using only real sector parameters in financial statements) with each of a ranking of market valuations and inferences from implementation of asset pricing models is shown to suffice for implementation of model predictions. Using data for three publicly quoted firms, empirical results provide robust validation for formal theoretical predictions.