Stock Prices and Fundamentals

We consider a variety of fundamentals-based explanations for the recent stock price run-up, including changes in preferences, dividend growth rates, and the extent of risk sharing. In a calibrated OLG model we focus on two aspects of risk sharing-the market participation rate and the degree of diversification. We conclude that the relatively small changes in participation that have occurred over this decade are unlikely to be a major part of the explanation. Increased portfolio diversification, however, is likely to have had a larger effect. There is empirical evidence that households have significantly diversified their portfolios, selling individual stocks and buying mutual funds. An important difference between poorly diversified portfolios and investment in a market index is the reduced likelihood of catastrophic outcomes. When this is reflected in model parameters, the expected equity premium falls by more than 4%. More generally, we construct scenarios that are loosely consistent with the data in which the required return on stocks falls by 2%. Using a calibrated Gordon growth model, we find that this change in expected returns goes at least halfway towards justifying the current high level of the price-dividend ratio in the U.S. stock market.