Historical evidence indicates that stock prices fluctuate heavily compared to indicators of fundamental value. For example, the price to earnings ratio of the S&P500 was around 5 at the beginning of the 20s, but more than 25 about nine years later to fallback to about 5 again by 1933. In 1995 the price/earnings ratio of the S&P500 was close to 20, went up to more than 40 at the beginning of 2000 and then quickly declined again to about 20 by the end of 2003. Why do prices fluctuate so much compared to economic fundamentals?
This question has been heavily debated in financial economics. At the beginning of the 80s, Shiller (1981) and LeRoyand Porter (1981) claimed that the stock market exhibits excess volatility, that is, stock price fluctuations are significantly larger than movements in underlying economic fundamentals. The debate evolved in two directions. On the one hand, supporters of rational expectations and market efficiency proposed modifications and extensions of the standard theory.
In contrast, another part of the literature focused on providing further empirical evidence against the efficiency of stock prices and behavioral models to explain these phenomena. The debate has recently been revived by the extraordinary surge of stock prices in the late 90s. The internet sector was the main driving force behind the unprecedented increase in market valuations. Ofek and Richardson (2002,2003) estimated that in 1999 the average price-earnings ratio for internetstocks was more than 600.
A recent overview of rational explanations based on economic fundamentals for the increase in stock prices in the late 90sise.g. given by Heatonand Lucas (1999). They offer three reasons for the decrease of the equity premium, i. e. the difference between expected returns on the market portfolio of risky stocks and riskless bonds. A first reason is the observed increase of households'participation in the stock market. This implies spreading of equity risk among a larger population, which could explain a decrease of the risk premium required by investors. Secondly, there is evidence that investors hold more diversified portfolios compared to the past.
In the 70salarge majority of investors concentrated their equity holdings on one or two stocks. More recently households have invested a large proportion of their wealth in mutual funds achievingamuch better diversification of risk. Both facts justify a decrease of the required risk premium by investors. Although the wider participation seems unlikely to play an important role in the surge of stock prices in the 90s, the increased portfolio diversification could at least partly account for the decrease in the equity premium and the unprecedented increase in market valuations.
