How Investors Set Equity Prices
20 Pages Posted: 30 May 2015 Last revised: 31 Jul 2015
Date Written: June 4, 2015
Abstract
An equity pricing Model is developed based on the modulation of the long time average real earnings yield by investors’ changing expectations about returns arising from their current sentiment about the economy. The linear variation of the Univ. of Michigan Consumer Sentiment Index and the trailing earnings growth rate about their long term means can explain about 43% of the variation of the real earnings yield about its mean (1982:1 to 2013:12). During periods of extreme sentiment (bubbles, busts) non-linearites occur. When the non-linearities are modeled and included, the Model is able to explain about 71% of the variation, with a corresponding pricing error of ±13%. The feasibly of short and long time horizon price forecasts from the point of view of the Model are discussed.
Keywords: equity price model, asset price model
JEL Classification: G12
Suggested Citation: Suggested Citation