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Stocks For The Long Run Book

In 1981, Robert Shiller of Yale University devised a method of determining whether stock investors tended to overreact to changes in dividends and interest rates, the fundamental building blocks of stock values.14 From the examination of historical data, he calculated what the value of the S&P 500 Index should have been given the subsequent realization of dividends and interest rates.

We know what this value is because, as shown in Chapter 7, stock prices are the present discounted value of future cash flows. What he found was that stock prices were far too variable to be explained merely by the subsequent behavior of dividends and interest rates.

Stock prices appeared to overreact to changes in dividends, failing to take into account that most of the changes in dividend payouts were only temporary. For example, investors priced stocks in a recession as if they expected dividends to go much lower, completely contrary to historical experience.