, Volume 41, Issue 4, pp 631-650

Where are the sources of stock market mispricing and excess volatility?

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Abstract

Using a simple dividend model, we illustrate and synthesize the sources of stock market mispricing and excess volatility based upon two hypotheses—inflation illusion and heterogeneous beliefs. Our theoretical framework posits that equity mispricing arises when investors have subjective expectations about discount rates or dividend growth rates. We then analyze the sources of equity mispricing and market excess volatility under a VAR framework. Empirically, we find that both inflation illusion and heterogeneous beliefs explain equity mispricing. However, heterogeneous beliefs play a more important role in explaining stock mispricing in the long run. We also find that heterogeneous beliefs cause excess volatility, but inflation illusion does not. Therefore, dispersion in investors’ beliefs is a better explanation of stock market mispricing than the investors’ inability to properly discount future cash flows.