Stock Market Fundamentals and Bubbles: Implications for Prices, GDP and Consumption

Abstract

This paper examines the cointegrating relationships between UK quarterly stock prices, stock price fundamentals, GDP and consumption. Evidence reported supports cointegration between these four-variables, with results indicating three cointegrating vectors, or a single common stochastic trend. VAR models augmented with equilibrium relationships identified both separately and jointly from stock market and macroeconomic variables are estimated. The key results arising is that stock market fundamentals appear to drive the common stochastic trend, while deviations from stock market fundamentals, bubbles, have significant explanatory power for short-run movements in stock prices, GDP and consumption. This latter finding is confirmed using an alternate method for extracting the non-fundamental component from stock prices. Overall, these results suggest the importance of stock market fundamentals (ultimately corporate performance) as a driving force for long-run stock price and macroeconomic movement and of non-fundamental behaviour (ultimately confidence) for short-run changes in stock prices and macroeconomic activity.