Smart Money, Noise Trading and Stock Price Behaviour

This paper estimates an equilibrium model of stock price behaviour in which changes in exponentially de-trended dividends and prices are normally distributed and exogenous "noise traders" interact with "smart-money" investors who have constant absolute risk aversion. The model can explain the volatility and predictability of U.S. stock returns in the period 1871-1986 using either a low discount rate (4% or below) and a large constant risk discount on the stock price, or a higher discount rate (5% or above) and noise trading correlated with fundamentals. The data are not well able to distinguish between these explanations.