Valuation Implications of Market Incompleteness: A Robust Empirically Tractable Characterization of Stock Market Incompleteness

Abstract

This study shows listings of new issues that occur in sequence of increasing (the INCGE path), or decreasing (the DDGE path) average quality are general equilibrium listing paths, equivalently necessary conditions for maintenance of fairest valuations within stock markets. Introduction of pragmatism of nigh impossibility of satisfaction of either of the two paths induces either of systemic undervaluation or overvaluation of new issues. Given either of undervaluations or overvaluations are robust to efficiency of aggregation of information, the extent to which stock markets are incomplete, that is, extent of deviation from general equilibrium listing paths, is shown to be a more fundamental metric for fairness of price equilibriums than market efficiency. While it might seem, on the face of it, otherwise, if investors find cash flows and present values of cash flows more desirable than positivity of sequences of stock returns, the DDGE path is shown to strictly dominate the INCGE path. The finding that pattern of return persistence and reversals is rationalized by transitions between the two paths, and the finding that each of return persistence and reversals have structure of `return momentum' lends credence to potential of the general equilibrium paths for generation of new insights.

Keywords: Undervaluation, Overvaluation, Dividends, IPO Quality, General Equilibrium, Momentum, Reversals

JEL Classification: G14, G24, C62