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

Bong-Soo Lee

Journal of Financial and Quantitative Analysis, 1998, vol. 33, issue 1, 1-32

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.

Date: 1998
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