The Stock Market and the Corporate Sector: A Profit-Based Approach

The Jerome Levy Economics Institute Paper No. 146

16 Pages Posted: 16 Jun 1998

See all articles by Anwar M. Shaikh

Anwar M. Shaikh

The New School - Department of Economics; The Levy Economics Institute

Date Written: September 1995

Abstract

This paper shows that the empirical movements of stock prices can be explained directly by fundamentals. The real stock market rate of return is shown to closely track the real incremental rate of profit of the corporate sector, with the two rates displaying similar means and standard deviations. It is argued that the two are linked by capital flows between the sectors through a process we call "turbulent arbitrage". Actual equity prices closely track the prices closely track the prices warranted by this model, and unlike the standard results, are less volatile than the warranted ones. The theoretical approach taken in this paper implies that the incremental profit rate is the required rate of return for the stock market return. The observed volatility on stock market returns and prices arises from the fact that the required rate is itself highly volatile, driven by cyclical and other short term fluctuations in aggregate demand. It is then easy to see why conventional theoretical models, which typically assume constant required rates of return (discount rates) and constant dividend growth rates, are largely unable to explain the movements in stock prices. On the other hand, since the incremental rate of profit (net of interest) is essentially the change in earnings normalized by investment, the findings of this paper accord well the experience "on the street" that stock price movements are driven by interest rates and changes in earnings.

JEL Classification: G12

Suggested Citation

Shaikh, Anwar, The Stock Market and the Corporate Sector: A Profit-Based Approach (September 1995). The Jerome Levy Economics Institute Paper No. 146. Available at SSRN: https://ssrn.com/abstract=87648 or http://dx.doi.org/10.2139/ssrn.87648

Anwar Shaikh (Contact Author)

The New School - Department of Economics ( email )

66 West 12th St.
New York, NY 10011
United States

The Levy Economics Institute

Blithewood
Annandale-on-Hudson, NY 12504
United States
845-758-7729 (Phone)
845-758-1149 (Fax)

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