Stock Market Mispricing: Money Illusion or Resale Option?

Abstract

We examine two hypotheses to explain stock mispricing: (a) the money illusion hypothesis (Modigliani and Cohn (1979)) and (b) the resale option hypothesis (Scheinkman and Xiong (2003)). We find that the money illusion hypothesis may explain the level, but not the volatility of mispricing in the US market. By contrast, the stock resale option hypothesis, which stems from heterogeneous beliefs about future dividend growth rates and short-sales constraints, can explain both the level and the volatility of mispricing. The evidence suggests that while the two hypotheses complement each other in explaining the level of mispricing, the resale option hypothesis provides a more coherent explanation for asset price bubbles, in which extraordinarily high price levels are often accompanied by excessive volatility and frenzied trading.JEL classification: E31, E44, G12, G14

Mispricing and the cross-section of stock returns

“…For example, our results show that the mispricing measure is correlated with the usual proxies for subjective growth rates in the literature, including the book-tomarket (B/M) ratio, the earnings-to-price (E/P) ratio, the cash-flow-to-price (C/P) ratio, the past 5-year sales growth rank (GS), and the analysts' 5-year growth forecast (EG). These results are also consistent with the empirical evidence in Chen et al (2008) that this mispricing measure embodies investor speculation about future growth rates.…”

“…Under this view, the pricing error term, e t , may reflect systematic errors in expectations about growth rates. Both Brunnermeier and Julliard (2008) and Chen et al (2008) advocate this alternative hypothesis and find supporting evidence in housing and stock markets, respectively. This view is also consistent with evidence in LSV and La Porta (1996) that investors use subjective growth rates as they extrapolate or overreact to past growth performance.…”

“…Following Brunnermeier and Julliard (2008), and Chen et al (2008), we adopt a modelbased approach to estimate a stock's fundamental value component, and the corresponding mispricing component.…”

“…In this framework, we follow the approach of Brunnermeier and Julliard (2008), and Chen et al (2008) to measure ''mispricing'' as the difference between the observed price-dividend ratio and the expected price-dividend ratio (i.e., the ''fundamental'' value), estimated based on underlying discount rates and dividend growth rates. In this setup, we find that the observed price-dividend ratio is correlated with future stock returns.…”

Disappearing Money Illusion

“…A positive 2 can yield a positive relation between stock prices and expected in ‡ation when = 2 and = 3, cf. (18). To further distinguish between the two competing explanations for the positive relation between stock prices and future in ‡ation in the period 1871-1976, we turn to the term structure of real interest rates in the next section.…”