Present Value Model, Bubbles and Returns Predictability: Sector-Level Evidence

Abstract

Evidence regarding the validity of the present value model for stock prices has typically been assessed at index level. Moreover, such research typically rejects the model. In contrast research at the firm level is more supportive of the model. This paper, using the present value model as the base for analysis, considers sector level data. Three main objectives motivate the paper. First, to fill the gap in the research noted above. Second, to see if the recent technology bubble affected all other sectors. Third, to examine returns predictability using the present value model adjusted for the presence of bubbles. The results suggest, first, only limited support for the simple present value model, supporting the notion that as data are aggregated then the information content of dividends becomes obscured. Second, that the late 1990s bubble affected all sectors with the exception of the more traditional industrial sectors, which have seen significant price rises following the end of the early 2000s bear market. Third, a regime switching model that incorporates both a fundamental and bubble component demonstrates that when the bubble component is small the dividend yield acts as a reasonable predictor of sector returns, however, when the bubble is large prices become disconnected from dividends. The results here inform our knowledge of the present value model and should be of interest both to researchers attempting to model market behaviour and investors attempting to forecast it.