What drives equity values: fundamentals or net flows? An empircal analysis of the 1982--1999 United States stock market boom

This dissertation develops a supply and demand based theory of equity price determination to investigate the unprecedented run-up in U.S. equity values during 1982–1999. The model draws insight from both fundamental valuation analysis, and various speculative market theories. It also incorporates aspects of portfolio theory, Shiller\u27s (1984, 1989) model of fads, fashions and bubbles, Toporowski\u27s (1999) theory of capital market inflation and Minsky\u27s (1982) model of financial fragility. Based on the theoretical model and empirical evidence it is concluded that the bull market, while originating in increased corporate profitability, was driven to a larger extent by the significant reduction in the supply of equity and the enormous inflow of domestic and foreign funds into the stock market. In contrast, three influential theories regarding the bull market can be gleaned from the academic literature and business press: (1) the “new economy” hypothesis maintains that the boom was justified purely on the basis of discounted future dividends, (2) the declining risk premium theory holds that the required rate of return has fallen dramatically and (3) the speculative bubble hypothesis argues investors have underpriced risk and overestimated the profit potential of U.S. corporations. Our findings show these intuitively appealing answers to be incomplete. The quantitative analysis exploits the vector autoregressive technique, OLS, and the instrumental variables methodology. The evidence from Granger-causality tests, innovation accounting and the structural model approach is consistent with the hypothesis that net flows effectively set prices. The finding that mutual fund flows explain stock prices, even when controlling for fundamentals, suggests the validity of the “irrational exuberance” theory. Similarly, foreign portfolio flows impacting U.S. equity prices is consistent with the notion that internationalization has transformed financial markets. The significance of share issuance in explaining price movements contradicts both the notion that changes in the supply of equity are inconsequential for market valuation, and the theory that exuberant expectations alone explains the ascent in stock prices. Thus, we maintain that in 1999 U.S. equity valuations were unwarranted by fundamentals and the general case for the efficient market hypothesis, which marginalizes supply and demand changes, has been overstated