Nonlinear Mean Reversion in Stock Prices

In this paper we investigate the relation between stock prices and fundamental variables. First, we consider the ability of static and dynamic versions of the present value model to account for the dynamics of annual stock prices from 1871 until 2003. The results suggest that the market price experiences swings away from the fundamental valuation but reverts back in the long-run. We then consider whether the deviation of stock prices from the fundamental valuation can be characterized by a nonlinear adjustment process. We find that the data strongly support this hypothesis. Further, we find that the results are quite similar in both the pre- and post-90s periods.