Reference no: EM133558099
Question 1. The Shiller argument in Behavioral Finance (25 points).
In Lecture Note 2, we discussed the (Nobel-Prize winning) Shiller (1981) argument, which says that changes in rationally forecasted future earnings growth cannot explain the observed historical fluctuations of the stock market's price-to-earnings ratio. In this question, we would like to go over this argument again, to make sure that you fully understand it.
• 1a Suppose changes in rationally forecasted future earnings growth drive the fluctuations of the stock market's price-to-earnings ratio. Then, during periods of high price-to-earnings ratios, do investors forecast high or low earnings growth moving forward? Please explain why. [Hint: Think about the present-value formula on page 8 of Lecture Note 2.]
• 1b Suppose changes in rationally forecasted future earnings growth are the channel that drives the fluctuations of the stock market's price-to-earnings ratio. Now, given that investor forecasts are fully rational, what is this channel's predicted relationship between the stock market's current price-to-earnings ratio and its subsequent earnings growth over the next few years? Please explain your answer carefully.
• 1c What is the empirically observed relationship between the stock market's current price-to-earnings ratio and its subsequent earnings growth over the next few years? Comparing this empirically observed relationship with the predicted relationship from 1b, are they the same or different? What conclusion can you draw from this comparison?
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