Restrictions that a class of general equilibrium models place upon the average returns of equity and Treasury bills are found to be strongly violated by the U.S. data in the 1889-1978 period. This result is robust to model specification and measurement problems. We conclude that, most likely, an equilibrium model which is not an Arrow-Debreu economy will be the one that Simultaneously rationalizes both historically observed large average equity return and the small average risk-free return. 1.

Recent empirical research in finance has uncovered two families of pervasive regularities: underreaction of stock prices to news such as earnings announcements, and overreaction of stock prices to a series of good or bad news. In this paper, we present a parsimonious model of investor sentiment, or of how investors form beliefs, which is consistent with the empirical findings. The model is based on psychological evidence and produces both underreaction and overreaction for a wide range of parameter values. � 1998 Elsevier Science S.A. All rights reserved. JEL classification: G12; G14

We model consumption and dividend growth rates as containing (i) a small long-run predictable component and (ii) fluctuating economic uncertainty (consumption volatility). These dynamics, for which we provide empirical support, in conjunction with Epstein and Zin’s (1989) preferences, can explain key asset markets phenomena. In our economy, financial markets dislike economic uncertainty and better long-run growth prospects raise equity prices. The model can justify the equity premium, the risk-free rate, and the volatility of the market return, risk-free rate, and the price-dividend ratio. As in the data, dividend yields predict returns and the volatility of returns is time-varying.

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This paper uses a disaggregated approach to study the volatility of common stocks at the market, industry, and firm levels. Over the period 1962–1997 there has been a noticeable increase in firm-level volatility relative to market volatility. Accordingly, correlations among individual stocks and the explanatory power of the market model for a typical stock have declined, whereas the number of stocks needed to achieve a given level of diversification has increased. All the volatility measures move together countercyclically and help to predict GDP growth. Market volatility tends to lead the other volatility series. Factors that may be responsible for these findings are suggested.

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This paper -- a product of the Finance and Private Sector Development Division, Policy Research Department -- is pa't of a larger effort in the department to understand the links between the financial system and economic growth. The study was funded by the Bank's Research Support Budget under the research project "Stock Market Development and Financial Intermediary Growth" (RPO 679-53). Copies of this paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Paulina Sintim-Aboagye, room N9-030, telephone 202-473-8526, fax 202-525- 1155, Internet address psintimaboagye@worldbank.org. December 1996. (44 pages) The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less tban fully pollsbed. The papers carry the names of the authors and should be cited accordingly. Tbe findings, interpretations, and conclusions expressed m tbis paper are entirely those of tbe author. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent

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