Why Stock Prices are Mostly Right Most of the Time

Abstract

Seven financial and macroeconomic ratios explain 85% to 90% of the variation in the level of stock prices in relation to fundamental values. The predictor ratios represent profitability, income concentration, inflation, interest rates, economic stability, default risk and tax rates. Of these, inflation, default risk and economic stability are the dominant predictors. Almost all of the time the market responds rationally to the mix of stimuli provided by the predictors. In this sense, the market is efficient. On occasion market participants en masse act irrationally, and these occasions are evidenced by the outsize residual errors in the price-to-fundamental regressions.

Keywords: stock price levels, fundamental value, rational pricing, economic uncertainty, inflation, interest rates

JEL Classification: G12, G14