Do U.S. Stock Prices Deviate from Their Fundamental Values?: Some New Evidence

Abstract

We propose a new methodology to test Fama's (1991) contention that the present value model (PVM) should be augmented by time-varying expected inflation to more adequately account for actual stock price behavior. Unlike other methods, our testing approach can distinguish between the excess-price movement hypothesis of Shiller (1981) and the dividend-smoothing hypothesis of Marsh and Merton (1986). We decompose the levels (as opposed to the variances) of stock prices into their fundamental and non-fundamental elements in the context of a multivariate PVM cointegrating framework and utilize the Gonzalo and Granger (1995) procedure to formally test for the statistical significance of the non-fundamental component. Our results from monthly data for the post-WWII period do not support the inflation-augmented PVM since the non-fundamental component continues to achieve significance. This finding persists under alternative model specifications and data frequencies. The apparent failure of the traditional, rational-expectation, PVM model to adequately account for observed market behavior provides another piece of evidence supportive of Shiller's (1981) belief in some form of market "irrationality".

Keywords: Present value model, time-varying expected inflation, fundamental and non-fundamental values of stock prices, market rationality

JEL Classification: G12, G14