Share price deviations from fundamentals

Abstract

Financial markets play a vital role in the allocation of funds for investment at all levels of economic activity. Therefore, an understanding of the functioning of financial markets is a critical business skill. Yet, history proves financial markets to be erratic creatures. The purpose of this research report was to determine whether stock prices always reflect fundamentals or whether they display persistent deviations from their long-run equilibrium fundamental values due to irrational investor behaviour. The research was limited to earnings and dividends in terms of fundamentals and under- and overreaction in terms of investor behaviour. A two-regime non-linear dynamic model was applied to quarterly data of stock price, dividends and earnings for companies listed on the JSE Securities Exchange (“the JSE”) from 1980 to 2007. The results of the study demonstrate that although the South African equity market is not totally extreme, it contains quite substantial short-term noise. This outcome provides a compelling case for value investing. Against this backdrop, recommendations were made to individual investors and corporate managers.