Variance Bounds Tests and Stock Price Valuation Models

Abstract

Previous use of plots of stock prices and "perfect-foresight" prices p*"t as evidence of either "excess volatility" or nonconstant discount rates is invalid since by construction p*"t will differ form and be much smoother than rational prices if discount rates are constant. Further, prices appear nonstationary, which can account for the previously reported gross violations of variance bounds. Conditional variance bounds that are valid under nonstationarity are not violated for Standard and Poor's data. The results are consistent with changes in expectations of future cash flows causing changes in expectations future cash flows causing changes in stock prices.