EC4010 Notes, 2007/2008 (Prof.

Karl Whelan) 1
Topic 4: The Dividend-Discount Model of Asset Prices
The rest of this course will be devoted to shorter-run uctuations in asset prices, consump-
tion, and ination. In particular, we will model how expectations of future events tend to
inuence todays outcomes.
Rational Expectations and Macroeconomics
Almost all economic transactions rely crucially on the fact that the economy is not a
one-period game. In the language of macroeconomists, most economic decisions have an
intertemporal element to them. Consider some obvious examples:
We accept cash in return for goods and services because we know that, in the future,
this cash can be turned into goods and services for ourselves.
You dont empty out your bank account today and go on a big splurge because youre
still going to be around tommorrow and will have consumption needs then.
Conversely, sometimes you spend more than youre earning because you can get a
bank loan in anticipation of earning more in the future, and paying the loan o then.
Similarly, rms will spend money on capital goods like trucks or computers largely in
anticipation of the benets they will bring in the future.
Another key aspect of economic transactions is that they generally involve some level
of uncertainty, so we dont always know whats going to happen in the future. Take two
the examples just give. While it is true that one can accept cash in anticipation of turning
it into goods and services in the future, uncertainty about ination means that we cant
be sure of the exact quantity of these goods and services. Similarly, one can borrow in
anticipation of higher income at a later stage, but few people can be completely certain of
their future incomes.
For these reasons, people have to make most economic decisions based on their sub-
jective expectations of important future variables. In valuing cash, we must formulate an
expectation of future values of ination; in taking out a bank loan, we must have some ex-
pectation of our future income. These expectations will almost certainly turn out to have
been incorrect to some degree, but one still has to formulate them before making these
decisions.
EC4010 Notes, 2007/2008 (Prof. Karl Whelan) 2
So, a key issue in macroeconomic theory is how people formulate expectations of eco-
nomic variables in the presence of uncertainty. Prior to the 1970s, this aspect of macro
theory was largely ad hoc. Dierent researchers took dierent approaches, but generally it
was assumed that agents used some simple extrapolative rule whereby the expected future
value of a variable was close to some weighted average of its recent past values. However,
such models were widely criticised in the 1970s by economists such as Robert Lucas and
Thomas Sargent. Lucas and Sargent instead promoted the use of an alternative approach
which they called rational expectations. This approach had been introduced in an impor-
tant 1961 paper by John Muth, and this original paper is worth reading even if it doesnt
have much discussion of the implications for macroeconomics.
1
The idea that agents expectations are somehow rational has various possible interpre-
tations. However, when economists say that agents in a model have rational expectations,
they usually mean two very specic things:
They use publicly available information in an ecient manner. Thus, they do not
make systematic mistakes when formulating expectations.
They understand the structure of the model economy and base their expectations of
variables on this knowledge.
To many economists, this is a natural baseline assumption: We usually assume agents
behave in an optimal fashion, so why would we assume that the agents dont understand the
structure of the economy, and formulate expectations in some sub-optimal fashion. That
said, rational expectations models generally produce quite strong predictions, and these
can be tested. Ultimately, any assessment of a rational expectations model must be based
upon its ability to t the relevant macro data.
Asset Prices
The rst class of rational expectations models that we will look relate to the determination
of asset prices. One reason to start here is that the determination of asset prices is a classic
example of the importance of expectations. For instance, when one buys a stock today, there
is usually no immediate benet at all: The benet comes in the future when one receives a
ow of dividend payments, and/or sells the stock for a gain. Similarly, when one purchases
1
John Muth. Rational Expectations and the Theory of Price Movements, Econometrica, July 1961.
EC4010 Notes, 2007/2008 (Prof. Karl Whelan) 3
an investment property, the benets accrue in the form of future rents received and capital
gains on sale. Another reason to study this topic is that understanding the behaviour of
asset prices is important for macroeconomists because the movements in wealth caused by
asset price uctuations have important eects on aggregate demand. Finally, as we will see
in the rest of the course, the theory of the determination of asset prices that we will present
her provides a very useful example of the type of methods used in the rational expectations
class of macroeconomic models.
Denitions
We will consider the case of an asset that can be purchased today for price P
t
and which
yields a dividend of D
t
. While this terminology obviously ts with the asset being a share
of equity in a rm and D
t
being the dividend payment, it could also be a house and D
t
could be the net return from renting this house out, i.e. the rent minus any costs incurred
in maintenance or managment fees. If this asset is sold tomorrow for price P
t+1
, then it
generates a rate of return on this investment of
r
t+1
=
D
t
+ P
t+1
P
t
(1)
This rate of return has two components, the rst reects the dividend received during the
period the asset was held, and the second reects the capital gain (or loss) due to the price
of the asset changing from period t to period t + 1. This can also be written in terms of
the so-called gross return which is just one plus the rate of return.
1 + r
t+1
=
D
t
+ P
t+1
P
t
(2)
A useful re-arrangement of this equation that we will repeatedly work with is the following:
P
t
=
D
t
1 + r
t+1
+
P
t+1
1 + r
t+1
(3)
Asset Prices with Rational Expectations and Constant Expected Returns
We will now consider a rational expectations approach to the determination of asset prices.
In this context, rational expectations means investors understand equation (3) and that all
expectations of future variables must be consistent with it. This implies that
E
t
P
t
= E
t
_
D
t
1 + r
t+1
+
P
t+1
1 + r
t+1
_
(4)
EC4010 Notes, 2007/2008 (Prof. Karl Whelan) 4
where E
t
means the expectation of a variable formulated at time t. The stock price at time
t is observable to the agent so E
t
P
t
= P
t
, implying
P
t
= E
t
_
D
t
1 + r
t+1
+
P
t+1
1 + r
t+1
_
(5)
A second assumption that we will make for the moment is that the return on assets is
expected to equal some constant value for all future periods:
E
t
r
t+k
= r k = 1, 2, 3, ..... (6)
This allows equation (5) to be re-written as
P
t
=
D
t
1 + r
+
E
t
P
t+1
1 + r
(7)
The Repeated Substitution Method
Equation (7) is a specic example of what is known as a rst-order stochastic dierence
equation.
2
Because such equations are commonly used in macroeconomics, it will be useful
to write down the general approach to solving these equations, rather than just focusing
only on our current asset price example. In general, this type of equation can be written as
y
t
= ax
t
+ bE
t
y
t+1
(8)
Its solution is derived using a technique called repeated substitution. This works as follows.
Equation (8) holds in all periods, so under the assumption of rational expectations, the
agents in the economy understand the equation and formulate their expectation in a way
that is consistent with it:
E
t
y
t+1
= aE
t
x
t+1
+ bE
t
E
t+1
y
t+2
(9)
Note that this last term (E
t
E
t+1
y
t+2
) should simplify to E
t
y
t+2
: It would not be rational
if you expected that next period you would have a higher or lower expectation for y
t+2
because it implies you already have some extra information and are not using it. This is
known as the Law of Iterated Expectations. Using this, we get
E
t
y
t+1
= aE
t
x
t+1
+ bE
t
y
t+2
(10)
2
Stochastic means random or incorporating uncertainty. It applies to this equation because agents do
not actually know P
t+1
but instead formulate expectations of it.
EC4010 Notes, 2007/2008 (Prof. Karl Whelan) 5
Substituting this into the previous equation, we get
y
t
= ax
t
+ abE
t
x
t+1
+ b
2
E
t
y
t+2
(11)
Repeating this method by substituting in for E
t
y
t+2
, and then E
t
y
t+3
and so on, we get a
general solution of the form
y
t
= ax
t
+ abE
t
x
t+1
+ ab
2
E
t
x
t+2
+ .... + ab
N1
E
t
x
t+N1
+ b
N
E
t
y
t+N
(12)
which can be written in more compact form as
y
t
= a
N1

k=0
b
k
E
t
x
t+k
+ b
N
E
t
y
t+N
(13)
The Dividend-Discount Model
Comparing equations (7) and (8), we can see that our asset price equation is a specic case
of the rst-order stochastic dierence equation with
y
t
= P
t
(14)
x
t
= D
t
(15)
a =
1
1 + r
(16)
b =
1
1 + r
(17)
This implies that the asset price can be expressed as follows
P
t
=
N1

k=0
_
1
1 + r
_
k+1
E
t
D
t+k
+
_
1
1 + r
_
N
E
t
P
t+N
(18)
Another assumption usually made is that this nal term tends to zero as N gets big:
lim
N
_
1
1 + r
_
N
E
t
P
t+N
= 0 (19)
What is the logic behind this assumption? One explanation is that if it did not hold then
we could set all future values of D
t
equal to zero, and the asset price would still be positive.
But an asset that never pays out should be inherently worthless, so this condition rules this
possibility out. With this imposed, our solution becomes
P
t
=

k=0
_
1
1 + r
_
k+1
E
t
D
t+k
(20)
EC4010 Notes, 2007/2008 (Prof. Karl Whelan) 6
This equation, which states that asset prices should equal a discounted present-value sum
of expected future dividends, is usually known as the dividend-discount model.
Constant Expected Dividend Growth: The Gordon Growth Model
A useful special case that is often used as a benchmark for thinking about stock prices is
the case in which dividend payments are expected to grow at a constant rate such that
E
t
D
t+k
= (1 + g)
k
D
t
(21)
In this case, the dividend-discount model predicts that the stock price should be given by
P
t
=
D
t
1 + r

k=0
_
1 + g
1 + r
_
k
(22)
Now, remember the old multiplier formula, which states that as long as 0 < c < 1, then
1 + c + c
2
+ c
3
+ .... =

k=0
c
k
=
1
1 c
(23)
This geometric series formula gets used a lot in modern macroeconomics, not just in exam-
ples involving the multiplier. Here we can use it as long as
1+g
1+r
< 1, i.e. as long as r (the
expected return on the stock market) is greater than g (the growth rate of dividends). We
will assume this holds. Thus, we have
P
t
=
D
t
1 + r
1
1
1+g
1+r
(24)
=
D
t
1 + r
1 + r
1 + r (1 + g)
(25)
=
D
t
r g
(26)
When dividend growth is expected to be constant, prices are a multiple of current dividend
payments, where that multiple depends positively on the expected future growth rate of
dividends and negatively on the expected future rate of return on stocks. This formula
is often called the Gordon growth model, after the economist that popularized it.
3
It is
often used as a benchmark for assessing whether an asset is above or below the fair value
3
The formula appeared in Myron Gordons 1962 book The Investment, Financing and Valuation of the
Corporation.
EC4010 Notes, 2007/2008 (Prof. Karl Whelan) 7
implied by rational expectations. Valuations are often expressed in terms of dividend-price
ratios, and the Gordon formula says this should be
D
t
P
t
= r g (27)
Two examples of dividend-price ratios are charted in Figures 1 and 2. Figure 1 shows the
dividend-price ratio for the US S&P 500 stock index. It shows that even after the post-2000
market crash, the dividend-price ratio remains very low by historical standards. Figure 2
is perhaps more topical. It shows an estimate of the rental-price ratio for Irish housing.
4
Not surpisingly given the massive growth in Irish house prices, this series has plummetted
in recent years. Is this an indication that Irish house prices are overvalued? Not on its
own, its not: Equation (27) shows that this ratio depends negatively on r which can be
viewed as the expected or required rate of return on the investment. The period since the
early 1990s has seen a very substantial reduction in the interest rates prevailing in the Irish
economy, so it would be surprising if, via arbitrage reasoning, required rates of return on
other assets such as houses had not also declined.
Allowing for Variations in Dividend Growth
A more exible way to formulate expectations about future dividends is to assume that
dividends uctuate around a steady-growth trend. An example this is
D
t
= c(1 + g)
t
+ u
t
(28)
u
t
= u
t1
+
t
(29)
These equations state that dividends are the sum of two processes: The rst grows at rate
g each period. The second, u
t
, measures a cyclical component of dividends, and this follows
what is known as a rst-order autoregressive process (AR(1) for short). Here
t
is a zero-
mean random shock term. Over large samples, we would expect u
t
to have an average
value of zero, but deviations from zero will be more persistent the higher is the value of the
parameter .
We will now derive the dividend-discount models predictions for stock prices when
4
Unlike the S&P 500 example, there is no ocial rent-price ratio series. This calculation uses the Irish
Permanent-ESRI new house price series as the denominator while the change over time in the numerator is
determined by the CPI for rents, and the level is pinned down by an estimate of average rents in 2003:Q3
obtained from the Quarterly National Household Survey.
EC4010 Notes, 2007/2008 (Prof. Karl Whelan) 8
dividends follow this process. The model predicts that
P
t
=

k=0
_
1
1 + r
_
k+1
E
t
_
c(1 + g)
t+k
+ u
t+k
_
(30)
Lets split this sum into two. First the trend component,

k=0
_
1
1 + r
_
k+1
E
t
_
c(1 + g)
t+k
_
=
c(1 + g)
t
1 + r

k=0
_
1 + g
1 + r
_
k
(31)
=
c(1 + g)
t
1 + r
1
1
1+g
1+r
(32)
=
c(1 + g)
t
1 + r
1 + r
1 + r (1 + g)
(33)
=
c(1 + g)
t
r g
(34)
Second, the cyclical component. Because E(
t+k
) = 0, we have
E
t
u
t+1
= E
t
(u
t
+
t+1
) = u
t
(35)
E
t
u
t+2
= E
t
(u
t+1
+
t+2
) =
2
u
t
(36)
E
t
u
t+k
= E
t
(u
t+k1
+
t+k
) =
k
u
t
(37)
So, this second sum can be written as

k=0
_
1
1 + r
_
k+1
E
t
u
t+k
=
u
t
1 + r

k=0
_

1 + r
_
k
(38)
=
u
t
1 + r
1
1

1+r
(39)
=
u
t
1 + r
1 + r
1 + r
(40)
=
u
t
1 + r
(41)
Putting these two sums together, the stock price at time t is
P
t
=
c(1 + g)
t
r g
+
u
t
1 + r
(42)
In this case, stock prices dont just grow at a constant rate. Instead they depend positively
on the cyclical component of dividends, u
t
, and the more persistent are these cyclical
deviations (the higher is), the larger is their eect on stock prices. To give a concrete
example, suppose r = 0.1. When = 0.9 the coecient on u
t
is
1
1 + r
=
1
1.1 0.9
= 5 (43)
EC4010 Notes, 2007/2008 (Prof. Karl Whelan) 9
But if = 0.6, then the coecient falls to
1
1 + r
=
1
1.1 0.6
= 2 (44)
Note also that when taking averages over long periods of time, the u components of
dividends and prices will average to zero. Thus, over longer averages the Gordon growth
model would be approximately correct, even though the dividend-price ratio isnt always
constant. Instead, prices would tend to be temporarily high relative to dividends during
periods when dividends are expected to grow at above-average rates for a while, and would
be temporarily low when dividend growth is expected to be below average for a while. This
is why the Gordon formula is normally seen as a guide to long-run average valuations rather
than a prediction as to what the market should be right now.
Problems for the Model
Despite its widespread popularity as an analytical tool in stock market analysis, the version
of the dividend-discount model that we have been analyzing has some problems as an
empirical model of stock prices. One important aspect of the data which doesnt match the
model is the volatility of stock prices. In an important 1981 contribution, Yale economist
Robert Shiller argued that stocks were much too volatile to be generated by this model.
5
To see Shillers basic point, note that the ex post outcome for a variable can be expressed
as the sum of its ex ante expectation and its unexpected component:
X
t
= E
t1
X
t
+
t
(45)
This means that the variance of X
t
can be described by
V ar (X
t
) = V ar (E
t1
X
t
) + V ar (
t
) + 2Cov (E
t1
X
t
,
t
) (46)
Now note that this last covariance termbetween the surprise element
t
and the ex-
ante expectation E
t1
X
t
should equal zero if expectations are fully rational. If there
was a correlationfor instance, so that a low value of the expectation tended to imply a
high value for the errorand this means that one could systematically construct a better
forecast. So, if expectations are rational, then we have
V ar (X
t
) = V ar (E
t1
X
t
) + V ar (
t
) (47)
5
Do Stock Prices Move Too Much to be Justied by Subsequent Changes in Dividends? American
Economic Review, June 1981
EC4010 Notes, 2007/2008 (Prof. Karl Whelan) 10
More importantly for our purposes
V ar (X
t
) > V ar (E
t1
X
t
) (48)
The variance of the ex post outcome should be higher than the variance of ex ante rational
expectation.
This reasoning has implications for the predicted volatility of stock prices. Equation
(20) says that stock prices are an ex ante expectation of a discount sum of future dividends.
Shillers observation was that rational expectations should imply that the variance of stock
prices be less than the variance of the present value of subsequent dividend movements:
V ar(P
t
) < V ar
_

k=0
_
1
1 + r
_
k+1
D
t+k
_
(49)
A simple check reveals that this inequality does not hold: Stocks are actually much more
volatile than suggested by realized movements in dividends.
6
Two other patterns that are related to Shillers ndings, but that shed extra light on
the problems for the dividend-discount model:
Dividend expectations cant be directly observed. But when economists use regression
models to forecast future values of dividends and plug these forecasts in as E
t
D
t+k
,
the resulting present value sums dont look very like the actual stock prices series.
For example, Campbell and Shiller (1988) nd that the dividend-price ratio is twice
as volatile as the series they generate from plugging in forecasts of dividend growth.
7
Shiller pointed out that there appears to be a lot of movements in stock prices that
never turn out to be fully justied by later changes dividends. Campbell and Shiller
(2001) go farther.
8
They point out that stock prices are essentially no use at all
in forecasting future dividends. They note that a high ratio of prices to dividends,
instead of forecasting high growth in dividends, tends to forecast lower future returns
on the stock market.
6
While technically, the innite sum of dividends cant be calculated because we dont have data going
past the present, Shiller lled in all terms after the end of his sample based on plausible assumptions, and
the results are not sensitive to these assumptions.
7
The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors, Review of
Financial Studies, Autumn 1988.
8
NBER Working Paper No. 8221.
EC4010 Notes, 2007/2008 (Prof. Karl Whelan) 11
To understand this last nding, look at the chart at the end of these notes. It
shows the dividend-price ratio for the S&P 500. Though it goes through long-lasting
swings, the ratio has still tended to revert over time to its mean of about 3.5 percent.
If the ratio doesnt predict future dividends, then this mean-reversion must imply
forecasting power of the ratio for future stock prices. In other words, if dividends
are low relative to prices (as they have been in recent years) then the future mean-
reversion is likely to occur through sluggish price growth, rather than through fast
dividend growth.
Time-Varying Expected Returns
This last nding suggests a way to mend the dividend-discount model and perhaps explain
the extra volatility that aects stock prices: Change the model to allow for variations in
expected returns. Again a solution can be derived using repeated substitution. Let
R
t
= 1 + r
t
(50)
and start again from the rst-order dierence equation for stock prices
P
t
=
D
t
R
t+1
+
P
t+1
R
t+1
(51)
Moving the time-subscripts forward one period, this implies
P
t+1
=
D
t+1
R
t+2
+
P
t+2
R
t+2
(52)
Substitute this into the original price equation to get
P
t
=
D
t
R
t+1
+
1
R
t+1
_
D
t+1
R
t+2
+
P
t+2
R
t+2
_
=
D
t
R
t+1
+
D
t+1
R
t+1
R
t+2
+
P
t+2
R
t+1
R
t+2
(53)
Applying the same trick to substitute for P
t+2
we get
P
t
=
D
t
R
t+1
+
D
t+1
R
t+1
R
t+2
+
D
t+2
R
t+1
R
t+2
R
t+3
+
P
t+3
R
t+1
R
t+2
R
t+3
(54)
The general formula is
P
t
=
N1

k=0
D
t+k
k+1

m=1
R
t+m
+
P
t+N
N

m=1
R
t+m
(55)
EC4010 Notes, 2007/2008 (Prof. Karl Whelan) 12
where
h

n=1
x
i
means the product of x
1
, x
2
.... x
h
. Again setting the limit of the t+N term to
zero and taking expectations, we get a version of the dividend-discount model augmented
to account for variations in the expected rate of return.
P
t
=

k=0
E
t
_
_
_
_
_
D
t+k
k+1

m=1
R
t+m
_
_
_
_
_
(56)
This equation gives one potential explanation for the failure of news about dividends to
explain stock price uctuationsperhaps it is news about future stock returns that explains
movements in stock prices.
What About Interest Rates?
Changing interest rates on bonds are the most obvious source of changes in expected returns
on stocks. Up to now, we havent discussed what determines the rate of return that investors
require to invest in the stock market, but it is usually assumed that there is an arbitrage
equation linking stock and bond returns, so that
E
t
r
t+1
= E
t
i
t+1
+ (57)
In other words, next periods expected return on the market needs to equal next periods
expected interest rate on bonds, i
t+1
, plus a risk premium, , which we will assume is
constant.
Are interest rates the culprit accounting for the volatility of stock prices? They are
certainly a plausible candidate. Stock market participants spend a lot of time monitoring
the Fed and the ECB and news interpreted as implying higher interest rates in the future
certainly tends to provoke declines in stock prices. Perhaps surprisingly, then, Campbell
and Shiller (1988) have shown that this type of equation still doesnt help that much in
explaining stock market uctuations. Their argument involves plugging in forecasts for
future interest rates and dividend growth into the right-hand-side of (56) and checking how
close the resulting series is to the actual dividend-price ratio. They conclude that expected
uctuations in interest rates contribute little to explaining the volatility in stock prices.
A recent study co-authored by Federal Reserve Chairman Ben Bernanke examing the link
between monetary policy and the stock market came to the same conclusions.
9
9
See What Explains the Stock Markets Reaction to Federal Reserve Policy?, by Ben Bernanke and
EC4010 Notes, 2007/2008 (Prof. Karl Whelan) 13
Time-Varying Risk Premia?
So, changes in interest rates do not appear to explain the volatility of stock market uctua-
tions. The nal possible explanation for how the dividend-discount model may be consistent
with the data is that changes in expected returns do account for the bulk of stock market
movements, but that the principal source of these changes comes, not from interest rates,
but from changes in the risk premium that determines the excess return that stocks must
generate relative to bonds: The in equation (57) must be changing over time. In an im-
portant 1991 paper, John Campbell argued this mechanismchanging expectations about
future equity premialies behind most of the uctuations in stock returns.
10
A problem with this conclusion is that it implies that, most of the time, when stocks
are increasing it is because investors are anticipating lower stock returns at a later date.
However, the evidence that we have on this seems to point in the other direction. For
example, in a recent paper, Northwestern University economist Annette Vissing-Jorgensen
found that even at the peak of the most recent bull market, most investors still anticipated
high future returns on the market.
11
Behavioural Finance
If one rejects the idea that, together, news about dividends and news about future returns
explain all of the changes in stock prices, then one is forced to reject the rational expecta-
tions dividend-discount model as a complete model of the stock market. What is missing
from this model? Many believe that the model fails to take into account of various hu-
man behavioural traits that lead people to act in a manner inconsistent with pure rational
expectations. Indeed, the inability to reconcile aggregate stock price movements with ra-
tional expectations is not the only well-known failure of modern nancial economics. For
instance, there are many studies documenting the failure of optimisation-based models to
explain various cross-sectional patterns in asset returns, e.g. why the average return on
stocks exceeds that on bonds by so much, or discrepancies in the long-run performance of
small- and large-capitalisation stocks.
Kenneth Kuttner, Journal of Finance, June 2005. The working paper version can be downloaded at
http://www.federalreserve.gov/pubs/feds/2004/200416/200416abs.html
10
A Variance Decomposition for Stock Returns, Economic Journal, March 1991
11
Perspectives on Behavioral Finance: Does Irrationality Disappear with Wealth? Evidence
from Expectations and Actions by Annette Vissing-Jorgensen. This paper can be downloaded at
www.kellogg.nwu.edu/faculty/vissing/htm/research1.htm
EC4010 Notes, 2007/2008 (Prof. Karl Whelan) 14
For many, the answers to these questions lie in abandoning the pure rational expecta-
tions, optimising approach. Indeed, the eld of behavioural nance is booming, with various
researchers proposing all sorts of dierent non-optimising models of what determines asset
prices.
12
That said, at present, there is no clear front-runner alternative behavioural-
nance model of the determination of aggregate stock prices. Also, one should not under-
estimate the rational expectations model as a benchmark. Given that low dividend-price
ratios tend not to be driven by rational expectations of low future returns, the ability of the
dividend-price ratio to predict future returns is probably due to a slow tendency of prices
to move back towards the fundamentals.
Does the stock market predictability associated with this return-to-fundamentals nding
imply that investors can beat the market and get better returns than the market by timing
their investmentsbuying when prices are low relative to dividends, and selling or shorting
the market when the reverse holds? Possibly, but it will always be dicult to distinguish
stock price uctuations due to rational responses to news about fundamentals (dividends
and rates of return) from those that constitute overreaction to fundamentals, or reaction to
things that have nothing to do with fundamentals. And the return predictability suggested
by the data is of a very long-horizon type. Dont expect to get rich quickly by timing the
market!
12
The papers presented at the bi-annual NBER workshop on behavioural nance give a good avour
of this work. See http://www.econ.yale.edu/shiller/behn/. See also Andrei Shleifers book, Inecient
Markets and Robert Shillers Irrational Exuberance
Figure 1
Dividend-Price Ratio for the S&P 500 (1947-2005)
1947 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002
0.01
0.02
0.03
0.04
0.05
0.06
0.07
Figure 2
Rent-Price Ratio for Irish Housing (1978:Q1-2006:Q2)
1978 1981 1984 1987 1990 1993 1996 1999 2002 2005
0.030
0.036
0.042
0.048
0.054
0.060
0.066
0.072
0.078
0.084