Stock Market Mispricing: Inflation Illusion or Resale Option?

Abstract

We develop a valuation framework that equity mispricing may arise when investors have subjective beliefs about either the discount rates or dividend growth rates. Two testable hypotheses - "inflation illusion" and "resale option" - are derived from this framework to explain mispricing. Although the former is well-documented, we are the first to test the latter in the U.S. equity markets. We find that the "resale option" hypothesis with an emphasis on heterogeneous beliefs and short-sales constraints can explain both the level and the volatility of mispricing over a century from 1900 to 2004, while the "inflation illusion" may only account for the level of mispricing in more recent history. Thus, the marginal contribution of the "resale option" hypothesis is substantial and economically significant. The evidence suggests that the "resale option" hypothesis may provide a unified framework in explaining equity mispricing and the concurrent excess volatility as well as trading frenzy during periods of asset price bubbles.

Keywords: equity mispricing, overconfidence, heterogeneous beliefs, resale option, inflation illusion, short-sales constraints, asset price bubbles

JEL Classification: G12, E44