Permanent, Temporary, and Non-Fundamental Components of Stock Prices

Bong‐Soo Lee

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Financial Markets and Investment Strategies Financial Analysis and Corporate Governance Market Dynamics and Volatility

Abstract

This paper identifies various components of stock prices and examines the response of stock prices to different types of shocks: permanent and temporary changes in earnings and dividends, changes in discount factors, and non-fundamental factors. The analysis is conducted in a log-linear structural VAR framework. I find that about half of the yearly variation in prices is not related to either earnings or dividend changes. Time-varying interest rates do not help explain the remaining price movements. However, time-varying excess stock returns (i.e., risk premiums) account for much of the remaining variation in stock prices, in particular, in the postwar period. As a result, the deviation of stock prices from these fundamentals reduces to about 10% of stock price movements and tends to persist for a while before it declines eventually. This finding seems more compatible with a fad rather than a bubble interpretation.

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References

1979Distribution of the Estimators for Autoregressive Time Series with a Unit Root 1988Testing for a Unit Root in Time Series Regression 1985Does the Stock Market Overreact?1980Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?1988The Dynamic Effects of Aggregate Demand and Supply Disturbances 1988Permanent and Temporary Components of Stock Prices 1988Stock Prices, Earnings, and Expected Dividends 1986The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors

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