Cointegration and tests of a present value model in the stock market

Abstract

The long-run relation between stock price and dividend is reinvestigated by applying the Canonical Cointegrating Regression. It is shown that the present value model implies either the levels or the log levels of stock price and dividend are cointegrated, when there are no rational bubbles. Both the deterministic and the stochastic components of stock price and dividend are examined in this study to determine the validity of the present value model. It is found that neither the levels nor the log levels of stock price and dividend are cointegrated. Rational bubbles may exist in the deterministic component of stock price and cannot be eliminated by the cointegrating vector.