RDP 2011-06: Does Equity Mispricing Influence Household and Firm Decisions? 1. Introduction

The existence of fads or bubbles in equity prices has been a question long debated by economists. Notable historical episodes of mispricing in equity markets that have been identified include the South Sea Bubble, the Great Railway Bubble, and the US Roaring Twenties. More recent examples of apparent bubbles include Japan's equity and property markets in the 1980s, and the US dot-com boom in the late 1990s. In view of these experiences, there has been ongoing interest in the extent to which equity price bubbles distort economic decision-making. However, somewhat surprisingly, there remains only a limited literature that attempts to quantify the effects of mispricing in equity markets on household and firm decisions.^[1]

To provide insight into this question, this paper focuses on identifying the quantitative effects of equity market mispricing on household consumption and portfolio allocation decisions, and firm dividend policies. If mispricing in equity markets exists, the distortion of price signals associated with household wealth held in the form of equity can affect household consumption and portfolio allocation decisions. In addition, mispricing can potentially affect corporate dividend policies. For example, if prices reflect that firms have overly optimistic expectations regarding their future profitability and investment opportunities, this optimism can lead firms to alter their dividend payment decisions. I focus on whether these effects are economically significant. That is, do households consume more or less during a bubble, purchase more or less equity, and do firms change their dividend policies?

There is an extensive literature that seeks to test or identify the existence of equity price bubbles.^[2] However, rather than focusing on tests of existence, this paper takes the view that mispricing shocks exist, and then explores their effect on economic decision-making. It builds on ideas that have previously been used to identify mispricing shocks, including the idea that these shocks should be viewed as transitory^[3] and that there exist observable proxies that are correlated with mispricing, but uncorrelated with changes in fundamentals.^[4] The contribution is to show how both of these ideas can be incorporated in a simple estimation framework that permits analysis of the effects of equity market mispricing.

Using data for the United States, I estimate a system that allows identification of the effects of mispricing shocks on household consumption and portfolio allocation decisions, firm dividend decisions, and equity prices. The proxies for mispricing that I consider are a measure of analyst forecast dispersion (see Diether et al (2002); Gilchrist et al (2005)), a survey measure of perceived misvaluation (see Shiller (2000b)), and a measure of expected short-term volatility in equity prices. Importantly, these proxies provide information for identifying equity mispricing that is useful in the case that they are correlated with mispricing, but uncorrelated with shocks to fundamentals.

The identification approach suggested in this paper is informative for several reasons. The first is that it does not rely on the restriction that mispricing has no effect on economic decisions a priori, and is therefore well equipped to identify the effects of bubbles.^[5] A second advantage is that the method proposed here does not require a unique model of the fundamental structure of the economy. In econometric terms, identifying the effects of the non-fundamental transitory (mispricing) shock does not require identification of the permanent (fundamental) shocks to the system. From this perspective, the methodology proposed can be considered consistent within a class of economic models of fundamentals, rather than requiring a unique model of fundamentals to be identified.

Importantly, the restrictions imposed for identification are made explicit. This is in contrast to statistical approaches used to identify bubbles where the restrictions imposed can be opaque, and the ability to identify the effects of bubbles on economic decisions remains unclear.^[6]

The next section outlines related empirical literature. Section 3 outlines the estimation methodology and the approach to identification. Sections 4 and 5 are concerned with the empirical application and the main results. Section 6 considers robustness, and some conclusions are drawn in the final section.

Footnotes

Examples of such literature include Chirinko and Schaller (2001) and Gilchrist, Himmelberg and Huberman (2005), both of which focus on the effects of bubbles on firms' investment decisions. [1]

See, for example, Vissing-Jorgensen (2003) and Gürkaynak (2008) for reviews of this literature. [2]

For example, this is implicit in the work of Lee (1998). Transitory shocks are defined in this paper as perturbations that can affect short- but not long-run forecasts. In contrast, permanent shocks are innovations that can influence both short- and long-run forecasts. [3]

See, for example, Diether, Malloy and Scherbina (2002) and Gilchrist et al (2005). [4]

This is in contrast to previous literature, such as Lee (1998), which assumes that mispricing has no real effects. [5]

Helbling and Terrones (2003) and Detken and Smets (2004) are examples of purely statistical approaches that measure reduced-form correlations between bubbles and economic variables of interest. [6]