New Evidence for the Present-Value Model of Stock Prices: Why the REH Version Failed Empirically

Shiller (1981) and others have shown that the quantitative predictions of the REH present-value model are inconsistent with time-series data on stock prices and dividends. In this paper, we assess the empirical relevance of the model without explicitly representing how a rational market participant forecasts dividends and interest rates. We find that stock prices are driven largely by news about fundamental factors. Moreover, this news moves prices through changes in the market’s forecasts of dividends and/or interest rates in ways that are remarkably consistent with the present-value model. We also find that the structure of the process underpinning stock prices undergoes quantitative change, and that both fundamental and psychological factors play an important role in this process. Taken together, Shiller’s findings and ours point to a novel explanation of the present-value model’s empirical difficulties. They also imply that macroeconomists and finance theorists should rethink how to represent rational forecasting in real-world markets.