Do UK stock prices deviate from fundamentals?

This article examines the deviation of the UK total market index from market fundamentals implied by the simple dividend discount model and identifies other components that also affect price movements. The components are classified as permanent, temporary, excess stock return and non-fundamental innovations to stock prices by employing a multivariate moving-average model as applied in [J. Financial Quant. Anal. 33 (1998) 1] and imposing relevant restrictions on the model in light of Sims–Bernanke forecast error variance decomposition. We find that time-varying discounted rates play an active role in explaining price deviations. Under the assumption of constant expected excess returns, a substantial proportion of price movements observed is due to un-explained market non-fundamental innovations (Model I). However, the un-explained portion dropped dramatically once the excess stock returns were allowed to change over time and incorporated in the model (Model II). Amongst other implications, this finding suggests that apart from the dividends, the deviation in stock prices can also be attributed to other market fundamental elements.