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Rationality in the Present-Value Model of Stock Prices: Fundamentals, Psychology, and Structural Change

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The present-value model of stock prices is a workhorse in financial economics. The model relates today’s price of a stock (or a basket of stocks) to the market’s forecasts of next-period’s price and dividend, appropriately discounted.

This specification formalizes the commonsense notion that a rise in the market’s price or dividend forecast will lead to a rise in the stock price today. The time series implications of the model depend on how the market’s price and dividend forecasts are assumed to unfold over time. The standard solution makes use of the rational expectations hypothesis (REH). This hypothesis assumes that market participants can fully foresee when and how their understanding of the price and dividend process changes over time. Economists usually assume that this understanding not only does not change in unexpected ways, but does not change at all. A typical solution assumes a constant discount factor and a dividend process that follows a random walk with constant drift. The resulting REH-based present-value model implies that stock-price movements relative to the known constant drift occur only because of random disturbances to the dividend. According to this model, stock prices fluctuate so as to maintain a constant price-dividend ratio.

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