ARE UK SHARE PRICES TOO HIGH? FUNDAMENTAL VALUE OR NEW ERA
Article first published online: 8 JAN 2009
© 2009 The Author. Journal compilation © 2009 Blackwell Publishing Ltd and the Board of Trustees of the Bulletin of Economic Research.
Bulletin of Economic Research
Volume 61, Issue 1, pages 1–20, January 2009
How to Cite
McMillan, D. G. (2009), ARE UK SHARE PRICES TOO HIGH? FUNDAMENTAL VALUE OR NEW ERA. Bulletin of Economic Research, 61: 1–20. doi: 10.1111/j.1467-8586.2008.00290.x
- Issue published online: 8 JAN 2009
- Article first published online: 8 JAN 2009
- bond–equity yield;
- present value model;
- structural breaks
Since the mid-1990s the dividend yield reached and largely remained at a historically low level, even accounting for the stock market correction in the early 2000s. This appears to suggest that prices are overvalued. However, alternative valuation models based upon comparing bond and equity yields suggest that, if anything, prices are undervalued. This paper seeks to provide answers to this seeming paradox. Preliminary results suggest non-stationarity of the dividend yield and bond yield–equity yield differential, although the yield ratio is possibly stationary, casting doubt on mean reversion. Evidence from structural breakpoint testing suggests that all measures have been subjected to several mean level shifts throughout the sample period, and notably within the last decade, such that each series now fluctuates around a mean level lower than that experienced previously. Thus, the lower dividend yield and lower bond–equity ratio do not necessarily imply equity mispricing but that concepts of pre-existing normal levels no longer apply. In explaining why higher equity prices are supported, we note that the last decade has seen a period of historically low and stable inflation and interest rates. Further, there is a strong positive relationship between inflation and the dividend yield. This more stable economic environment has led to more accurate valuation of stocks and lower required rates of return, thus supporting higher prices.