Stock Prices and Fundamentals in a Production Economy

Abstract

This paper compares the predictions for the market value of firms from the Gordon growth model with those from a dynamic general equilibrium model of production. The predictions for movements in the market value of firms in response to a decline in the required return or an increase in the growth rate of the economy are quantitatively and qualitatively different across the models. While previous research has illustrated how a drop in the required return or an increase in the growth rate of the economy can explain the runup in equity values in the 1990s in the Gordon growth model, the consideration of production overturns these results and illustrates that auxiliary implications of such shifts in fundamentals, such as a sharp increase in the investment intensity of the economy, are not supported by the data in the late 1990s. This tension between theory and data suggests that the skyrocketing market value of firms in the second half of the 1990s may reflect a degree of irrational exuberance.

Keywords: asset pricing, investment