Another look at the rationality of the stock market

Abstract

A model due to Lucas is estimated between the real stock market returns and real dividends on the market index. The sample spans the period from 1872 to 1987 on an annual basis. The results are close to theoretical expectations: the coefficient of relative risk aversion, which minimizes the sum of square residual, is estimated to be around 0.89, and the discount rate around 8%. This means that a relatively simple valuation model is capable of describing the stock market, lending support to the rationality of this market.