Dividend Policy and Stock Price Volatility

Abstract

The idea that speculative prices fully and correctly reflect available information is central to modern financial economic theory. However, there is growing evidence that the capital markets may not be informationally efficient and a significant strand of research in the financial economics literature suggests that changes in speculative prices are too volatile to be accounted for by changes in information on economic fundamentals alone. Figure 1, page 64, (from A. Kleidon, 1986a) plots the real value of the Standard and Poor’s annual composite index of the U.S. stock market over the past century alongside the ex post realized present value of future dividends ¹⁶. Plots like these ¹⁷ show clearly that the stock market has exhibited large fluctuations relative to the baseline of the ex post perfect foresight value. Indeed, at times the real S&P stock market index has been more than twice and at times less than half of what its smoothly-growing ex post perfect foresight value turned out to be. Similar considerations hold for the U.K. Stock Market. Shiller (1981) and LeRoy and Porter (1981) argued that such high volatility relative to perfect foresight fundamental posed severe difficulties for the Efficient Market Hypothesis (EMH). The point here is that a good forecast has to be less variable than, or at most as variable as, the quantity forecasted. Consequently, plots like Figures 1 and 2 seem to contradict the assumption that the current price is a good forecast of the perfect foresight fundamental. Thus, this excess volatility of the market appeared to be strong evidence against the EMH.