Abstract
This paper considers deviations of U.S. stock prices from their value warranted by expected growth in output. We begin by assuming that the return required by wealth holders is constant, and then relax this assumption by allowing the risk-free rate to vary over time and the risk premium to be time varying. The time-varying risk model produces fundamental prices that are closest to actual prices. The time-series characteristics of deviations from fundamental value suggest that deviations are similar over different time horizons and observational frequency and appear to be driven by nonlinearities in the price–output relationship rather than irrational investor behaviour.
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