Valuation Ratios and Price Deviations from Fundamentals

Posted: 30 Mar 2006

See all articles by Ana-Maria Fuertes

Ana-Maria Fuertes

Cass Business School, City University of London

Jerry Coakley

University of Essex - Essex Business School

Abstract

This paper sheds light on US stock price deviations from fundamentals by analyzing the time-series dynamics of post-1870 S&P valuation ratios. It employs a non-linear, two-regime framework that allows for different behavior over phases of the stock market cycle. Persistence in the ratios implies prolonged price deviations from fundamentals stemming from short run continuation fueled by investor sentiment during bull markets. However, the pull from fundamentals ensures that valuation ratios and prices move toward their equilibrium levels in bear markets. Impulse response functions highlight sluggish adjustment and indicate that the effects of positive shocks are more pronounced and long-lasting in bull markets. The main conclusion is that, while market sentiment plays an important transitory role, valuation ratios do mean revert and so prices reflect fundamentals in the long run.

Keywords: Fundamentals, Behavioral finance, Investor sentiment, Threshold autoregression

JEL Classification: C40, G12

Suggested Citation

Fuertes, Ana-Maria and Coakley, Jerry, Valuation Ratios and Price Deviations from Fundamentals. Journal of Banking and Finance, Vol. 30, 2006; Cass Business School Research Paper. Available at SSRN: https://ssrn.com/abstract=892590

Ana-Maria Fuertes

Cass Business School, City University of London ( email )

Faculty of Finance
106 Bunhill Row
London, EC1Y 8TZ
United Kingdom
+44 207 477 0186 (Phone)
+44 207 477 8881 (Fax)

HOME PAGE: http://www.city.ac.uk/people/academics/ana-maria-fuertes

Jerry Coakley (Contact Author)

University of Essex - Essex Business School ( email )

Wivenhoe Park
Colchester, CO4 3SQ
United Kingdom
+44 1206 872455 (Phone)
+44 1206 873429 (Fax)

HOME PAGE: http://www.essex.ac.uk/afm/staff/coakley.shtm

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