Determinants of Stock Prices

Abstract

In this article, the author presents a simple stock price model for major country economies. The model assumes a long-run fair stock market value and short-run deviations from fair value. In the long run, only fundamentals matter. In addition to the discussion of earnings and the risk-free interest rate, the author considers a proxy for the long-run equity risk premium. In the short run, other factors might determine stock prices, such as the exchange rate, commodity prices, momentum, and seasonality. Out-of-sample forecasting statistics indicate that the stock price model clearly outperforms a random walk model. Exploiting the forecasting accuracy in practice is difficult, however, because the stock price determinants, especially the short-run risk premium, are difficult to predict. By contrast, the long-run stock price model reliably guides investors about the degree of over or undervaluation of stock markets from their long-run fair fundamental levels. Two different investment strategies illustrate the ability of the long-run stock price model to generate excess returns.