Irrational Exuberance Reconsidered

Fundamental valuation and stock market overreaction are among the major concerns of portfolio managers and equity analysts alike. In this chapter we provide a broader view on fundamental valuation and investor psychology. A discussion round with practitioners from equity research and portfolio management provides the reader with insights into the way investment practitioners take into account for both factors. In addition, we discuss two issues which have raised major attention recently: the equity risk premium and corporate control.

This book is concerned with stock market overreaction, i.e. the possibility that temporarily the valuation of stocks is out of line with fundamental valuation. Fundamental valuation means valuation based on discounted cash flows. The hypothesis of stock market overreaction is a major concern for private investors and portfolio managers alike. If they are able to identify temporary overreaction in the stock market, they will be able to earn an extra return. According to standard theory in finance that should not be possible.

This chapter first reviews the methodology and the main findings of the winnerloser effect in the literature. Second, I relate these findings to the concept of market efficiency. Then I review three types of explanations which have been proposed in the literature. Finally, I have a more detailed look at those papers which are most closely related to my own investigation.

Starting point for my own analysis of intertemporal dependence in the German stock market is the winner-loser hypothesis of DeBondt and Thaler (1985). In this chapter I reinvestigate this hypothesis for the cross section of German stock returns from 1968 to 1986.

From a theoretical point of view the decisive question is whether it is possible to explain the winner-loser effect within a framework of rational asset pricing. In empirical asset pricing models stock returns are related to aggregate pricing variables. In the CAPM stock returns are related to the market rate of return. This is the first approach which I explore. The alternative approach which I pursue is that stock returns are related to fundamentals such as dividends and profits. From a theoretical point of view the question arises what this relationship implies. Two interpretations can be offered. The first is that unexpected movements in fundamentals lead to unexpected returns. Investors are surprised by movements in fundamentals. An unexpected increase in profits leads to a positive excess return, an unexpected loss to a negative excess return. I also offer a second interpretation. Expected movements in fundamentals lead to expected returns. In a framework of rational asset pricing I investigate whether expected returns might be driven by expected changes in fundamentals.

Long-term reversals in stock returns can have two implications. Most of the literature has attributed them to an inefficiency of the stock market which is caused by irrational behaviour of market participants. This chapter follows a different line of reasoning. In a rational asset pricing model excess returns should be due to an additional exposure to systematic risk. If after high [low] realized returns low [high] returns are expected, then long-term reversals are in line with capital market theory. To investigate this question it is necessary to measure the exposure to systematic risk. In this chapter I investigate to which extent the CAPM as the simplest asset pricing model can explain the observed excess returns.

Ever since people have invested their money into stocks they have been interested in the forces which drive stock returns. First, an analysis of these forces helps the investor to understand why stock returns have developed in a certain way during the past. Second, it might help him to make better investment decisions during the future. The main question of this chapter is which are the variables which explain the cross section of stock returns. I relate the cross section of stock returns to two sets of explanatory variables, the CAPM β and size on the one hand and to fundamentals on the other hand. I have already used these variables to explain stock returns in previous chapters. Starting point there has been the observed time series pattern. The main part of the analysis has concentrated on the explanation of long-term reversals in the cross section of excess returns. The CAPM showed only limited explanatory power whereas the pattern in fundamental variables was in line with the pattern of excess returns. This evidence suggests that fundamentals explain the cross section of stock returns better than the CAPM β. In this chapter, I test for differences in the explanatory power directly.

In this chapter I investigate whether cycles in stock returns are related to temporary problems in corporate control. This approach broadens the perspective of my analysis. Properties of returns and fundamentals are related to the theory of management control. The main hypothesis is that firms which show cycles in their performance suffer from temporary problems of corporate control. I pursue this hypothesis by an analysis of accounting data. Jensen (1986) has related problems of corporate control to the available free cash flow. An abundance of free cash flow loosens management control and as a consequence management performance deteriorates. From this idea I derive hypotheses with respect to different accounting variables. This section presents hypotheses, the empirical results and a discussion. In an appendix I deliver a more complete analysis of the payout decision.

The standard paradigm in financial economics assumes that stock market valuation is in line with fundamentals. Rational investors discount cash flows appropriately and markets clear at a price which accounts for the fundamental characteristics of the stock. Recent turmoils in the stock market have cast some doubt on this hypothesis. Irrational exuberance has become a major concern of central bankers, policy makers, and investors alike.