Present Value Models and the Behaviour of European Financial Markets

According to the efficient markets hypothesis stock returns should not be predictable on the basis of information available to economic agents in any given time period. We test the hypothesis using security market panel data for the top five Eurozone countries. In static return regressions there is a positive and significant relation between stock returns at horizons of 1–12 months and the dividend/price ratio. A dynamic vector autoregression model shows, that the cross-sectional variability of actual stock prices is significantly lower than predicted. In the time dimension actual stock prices are more volatile than predicted ones, although their movements anticipate future dividend changes. We provide an interpretation of these results from the point of view of the cognitive sciences. The regression to the mean between prices and stock returns might be explained by an excess smoothness of stock prices along the cross-sectional dimension, due to the process of expectations formation. The excess sensitivity along the time dimension supports the notion of capital markets efficiency as a fundamental factor for the determination of security prices.