Stock Price Deviations From Fundamentals Levels: Mis‐Valuation due to Investor Overconfidence?

ABSTRACT We use the Residual Income Valuation Model to obtain fundamental values for sample stocks in six Eurozone markets. We then estimate the deviation between the fundamental values and actual stock prices. Subsequently, we examine whether these deviations can be systematically explained by business cycle trends, trends in local economic sentiment, global market‐related uncertainty and developments in global energy prices. We find that market volatility, proxied by the CBOE Volatility Index (VIX), is an important factor, along with energy prices. Findings are similar when a second proxy for price deviations, based on Cochrane's (1994) methodology, is employed. Impulse Response Functions indicate that a shock increase in VIX tends to reduce the deviation between fundamental and actual stock prices in sample markets. We argue that the VIX serves as a contrarian indicator of market overconfidence, such that higher VIX levels are associated with lower investor overconfidence and, consequently, with smaller price deviations from their fundamental values. Conversely, lower VIX levels (i.e., heightened overconfidence) are associated with larger price deviations.