No. 378 - Stock Values and Fundamentals: Link or Irrationality?

In this paper, econometric techniques are employed to analyze the continuous and remarkable growth which has characterized international stock markets since 1995. The Campbell and Shiller dividend discount model, a dynamic version of Gordon’s formula commonly employed by financial analysts to rate individual firms, is the main tool of the paper. Given the information set available at any time, the future values of the real interest rate and the expected growth of dividends are evaluated and employed as explanatory variables for the current dividend yield. The results of the econometric analysis demonstrate that current dividend yields are not in line with the expected trend in the underlying variables, for all the countries considered. A decline in the real interest rate or an increase in the expected growth of dividends, or a combination of the two, could reconcile fundamentals and current dividend yields. The assessment of whether or not such divergences are rational cannot be made safely on the basis of expectations of the fundamentals derived from the econometric scheme. These, in fact, rest on the hypothesis of rational expectations for agents utilizing the full information set of past information of course, information related to a larger set, including survey data, or the effects of shifts in economic regimes are excluded in this setup.