What Moves Prices? The Dynamics of Fundamentals and Returns

Abstract: We propose a dynamic model that jointly explains up to 42% and 31% of out-of-sample variation between 1999 and 2020 in annual dividend growth and return on the aggregate S&P500 index. To proxy the time-variation of investors' beliefs, we combine penalized autoregressive methods and predictors that summarize a large share of information available on the market. We use model-implied conditional expectations and present value identities to investigate what drives the variations in the price-to-dividend and price-to-earnings ratios. We find that unconditionally time-varying expected return explains most of the movement in the valuation ratios, but over the last twenty years, the contribution of time-varying expectations on fundamentals has significantly increased.