The Behaviour of UK Stock Prices and Returns: is the Market Efficient?

Abstract

The VAR methodology of Campbell and Shiller () is employed under four different assumptions regarding equilibrium expected returns to assess the efficiency of the UK stock market. In our first model, equilibrium expected (real) returns are assumed to be constant, while in the second model, excess returns are assumed to be constant. The next two models assume that equilibrium returns depend upon a time-varying risk premium which varies with the conditional expectation of the return variance (i.e. the CAPM). Our results yield evidence of short-termism, even when the key assumption of a time-invariant discount rate is relaxed.We employ the VAR methodology pioneered by Campbell and Shiller (, , ) to test the efficiency of the UK stock market. The evidence presented here complements that obtained using variance ratio tests (for an overview see Shiller ()) and direct tests of the rational valuation formula (i.e. that stock prices equal the discounted present value of expected future dividends) using cross-section data (e.g. Miles ()).Bulkley and Tonks () applied Shiller-type variance bounds tests to annual UK time-series data. Assuming constant equilibrium returns, they found that the variance bound was strongly violated, and proffer an explanation based on the strong-form\weak-form rational expectations distinction. In this paper, we consider an alternative possibility ; that equilibrium returns are non-constant, and that existing models of time-varying equilibrium returns provide sufficient variation in discount rates so that prices are not excessively volatile.The VAR approach has several potential advantages over alternative test procedures. Within a single framework we can test for the predictability of oneperiod returns (e.g. Clare et al. (), MacDonald and Power (), Keim and Stambaugh ()) and multi-period returns (Fama and French  a, b), and also perform tests based on stock prices using the rational valuation formula (RVF)."Bulkley and Tonks conduct their analysis assuming real (detrended) stock prices and dividends are stationary processes (an assumption borne out by their DF statistics). However, the extra data since ,# together with revisions to the original series, mean that this assumption is no longer empirically tenable. The VAR methodology takes explicit account of the non-stationarity in the data, as well as allowing tests of the efficient markets hypothesis (EMH) under a wide variety of assumptions about the determinants of equilibrium returns.Finally, the large number of metrics (marginal probabilities, descriptive statistics, and graphs) afforded to us by the VAR methodology allows one to make an informed judgement on the degree to which the model is in conformity " The RVF states that the current price of a stock equals the expected discounted sum of future dividend payments.#  is the end of Bulkley and Tonks's data period.[  ]$ Because we have end-of period observations, whereas Campbell and Shiller (, ) used opening prices, our time su...

Risky Arbitrage, Limits of Arbitrage, and Nonlinear Adjustment in the Dividend‐Price Ratio

“…9. The estimates of are derived from OLS and Johansen ML estimation of the cointegrating vector of real stock prices and real dividends and are consistent with previous studies, see for example, Campbell and Shiller (1987), Campbell and Shiller (1988b) and Cuthbertson, Hayes and Nitzsche (1997). presence of outliers which might spuriously generate evidence of nonlinearity.…”

“…The loglinear representation of the present value model of stock prices also implies a number of highly nonlinear crossequation restrictions similar to those encountered in rational expectations models, as in Campbell and Shiller (1988b), Cuthbertson (1996), and Campbell, Lo, and MacKinlay (1997). Campbell and Shiller (1988b) show that, given , the restrictions can be simplified to a linear form.…”

“…Visual examination of the series does not suggest the presence of a regime shift in the data or the 8. Previous evidence of cointegration between log real stock prices and dividends is mixed, see for example, Campbell and Shiller (1988a,b) and Cuthbertson, Hayes and Nitzsche (1997). The majority of studies find weak support for the cointegrating relationship and a stationary log dividend-price ratio.…”

UK Stock Returns and the Impact of Domestic Monetary Policy Shocks

“…This result is consistent with Campbell and Ammer (1993). Cuthbertson et al (1999) also find that news about future excess returns is the dominating force behind movements in UK stock returns. Bernanke and Kuttner (2005) analyse the impact of monetary surprises on revisions in expected excess returns by including the surprise element in monetary policy as an exogenous variable in the forecasting VAR:…”

“…If stock prices reflect the discounted stream of future dividends, changes in current excess returns could be due to revisions in expectations of future dividends, interest rates or excess returns. Campbell (1991) and Campbell and Ammer (1993) advanced an approach to decompose surprise changes in excess returns into revisions in future dividends, real rates or future excess returns while Cuthbertson, Hayes and Nitzsche (1999) and Engsted and Tanggaard (2004) have applied this approach to explain movements in UK stock returns.…”