Steven E. Bolten;* University of South Florida, and Robert A. Weigand, University of Colorado at Colorado Springs
This paper demonstrates that the relation between stock market and business cycle dynamics can be conceptualized using a dividend discount model. The interaction of changes in earnings and interest rates throughout the economic cycle are shown to cause changes in the level of stock prices. This implies that monitoring and forecasting these factors can help explain and possibly predict stock price behavior over time.
Keywords: business cycle, forecasting, stock prices
JEL Classifications: G14/G10/E32
A large body of research has focused on the predictability of stock prices. These researchers invariably find that changes in stock prices are positively related to corporate earnings and negatively related to changes in interest rates, and that the stock market leads the economic cycle. Several studies have attempted to model stock prices and their relationship with earnings and interest rates ( Bolten, 1985, 1991; Bolten and Besley, 1986). Other authors ( Campbell and Schiller , 1988; Chen, 1991; and Fama, 1981) have shown that the current level of stock prices is related to the discounted value of future earnings and dividends. This paper contributes to our understanding of the valuation process by showing that a basic dividend discount model can capture the interaction between stock prices, corporate earnings and interest rates over time.
The organization of the paper is as follows. The next section provides a brief description of the stock market and economic business____________________