Fundamental UK stock prices as determined by the macroeconomy
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Angela Black* is a Professor of Finance in the Department of Accountancy and Finance at the University of Aberdeen. Her research interests include the relationship between investment performance and the macroeconomy. She teaches courses in business finance, personal finance and investment, derivatives, corporate finance and empirical methods in finance and has published papers in the Journal of Banking and Finance, Managerial Finance, Journal of Multinational Financial Management, Journal of Economics and Business and other professional and academic journals.
Patricia Fraser is Professor of Finance in the Department of Accountancy and Finance at the University of Aberdeen, where she has been since 1995. Her research interests are in applied financial economics, particularly the relationships between financial market prices and the current and expected performance of the real economy. She graduated with a PhD in 1990 (City University Business School, London), and since then her research has resulted in 49 peer-reviewed publications.
Nicolaas Groenewold is an Associate Professor in the Department of Economics at the University of Western Australia, where he has been since 1997. His research interests lie mainly in applied macroeconomics and financial economics, particularly in the interrelationship between the two areas. *Department of Accountancy and Finance, Edward Wright Building, Aberdeen, AB24 3QY, UK Tel: ⫹44 (0)1224 272205, Fax: ⫹44 (0)1224 272214, e-mail: [email protected]
Abstract This study uses a restricted vector-autoregressive model to derive a fundamental share price index that relates aggregate real share prices to real macroeconomic activity in the UK. The sample period covered is January 1974–December 2002. The analysis shows that actual (real) stock prices in the UK take long swings away from fundamental stock prices. It is noted that actual (real) stock prices fell below fundamental (real) stock prices in December 2002 for the first time since 1990. Keywords: real economy, fundamental share prices, vector-autoregression
Introduction Most financial analysts and academic papers use the dividend-discount model or financial ratio analysis to estimate a fundamental stock price. This is less than ideal since dividends may be managed or smoothed over time (see Ackert and Smith, 1993) and financial ratio analysis has little theoretical basis. This study constructs a theoretical fundamental stock price index that incorporates information
about the macroeconomy using the investor’s best forecast of the discounted present value of future real output with a time-varying risk premium.
Theoretical framework and empirical methodology Assuming perfectly competitive efficient markets and rational expectations, the representative firm, Vt, is the expected
䉷 Henry Stewart Publications 1479-179X (2003)
Vol. 4, 1, 5-9
Journal of Asset Management
5
Black, Fraser and Groenewold
value of its future real profits discounted at the real discount rate. Labour is bought in the labour market at a real wage
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