Uncertainty, sentiments and time-varying risk premia

Why are stock prices much more volatile than the underlying dividends an asset entitles to? The excess volatility of prices can in principle be attributed to two different causes: time-varying discount rates for expected future dividends, arising from variation in risk premia; or the irrational exuberance of investors, bidding prices up and down even in the absence of changes in the underlying value of the asset. No consensus has so far emerged among economists as to the prevalence of one or the other source of price variation. I propose in this paper a novel way to approach this problem, by identifying changes in the uncertainty faced by investors regarding the fundamental value of an asset and exploiting the different response in prices that such changes in uncertainty would generate through sentiments or risk premia. I then apply this framework to the S&P 500 index from 1872 till 2019: the positive correlation found between movements in uncertainty and in prices (or, equivalently, the negative correlation between movements in uncertainty and in implied risk premia) is not compatible with rational investors’ behavior and suggests instead the presence of a significant sentiments component in stock prices. • Paper looks at excess volatility in asset prices with new approach and methodology. • Evaluates co-movements between prices and uncertainty in fundamental value. • Positive co-movements not consistent with rational investors behavior. • Uses data on S&P500 to test new methodology and derives results.