Federal Reserve Bank of Cleveland
Press Release

For Release: June 6, 1997
Contact: June Gates, 216/579-2048

Stock Prices: Fundamentally Speaking

Investors and policymakers are concerned about whether soaring stock prices are justified by economic fundamentals or whether they are driven by mere speculation. In a recent Economic Commentary, Federal Reserve Bank of Cleveland Economist Joseph G. Haubrich says that analyses of the primary factors behind stock price fundamentals--including the dividend stream, payout ratio, and earnings growth--can fuel both optimistic and pessimistic predictions of market trends.

In one example, Haubrich uses estimates of expected dividend growth and investors’ required rate of return to calculate a “warranted” stock price, which he compares against actual stock prices. The comparison seems to tell a pessimistic story: Today’s stocks seem overvalued because dividend growth does not justify the surge in prices. Optimists however, disagree, saying earnings growth is more fundamental than dividend growth. They maintain that the recent explosion in corporate earnings will eventually result in larger dividends, thus justifying current high stock prices.

Although optimists and pessimists are divided on their interpretation of fundamental data, Haubrich says both camps should heed the importance of time-varying expected returns. He explains that, a generation ago, most people attributed shifts in stock market fundamentals to dividends or earnings. But over the past 15 years, academic finance literature has trumpeted a clear message: More variation in fundamentals, and hence in stock prices, results from variation in the risk factor and the expected return than was previously thought.

In conclusion, Haubrich notes that asset pricing is not an exact science. The market has crushed the bones of many a sure-fire scheme under the iron heel of its random walk. However, when apprising Wall Street's opportunities, an understanding of the forces driving market fundamentals may help to mitigate the market’s risk.

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