Do stock prices reflect their fundamentals? New evidence in the aftermath of the financial crisis

• We examine whether stock prices move in line with their fundamentals.
• We use data for six of the G7 countries covering the financial crisis.
• Fundamental shocks are identified through a long-run restriction in a SVAR model.
• We test this restriction using a Markov switching SVAR model in heteroskedasticity.
• We observe a self-correction of stock prices towards their fundamental values.

We re-examine the dynamic relations between stock prices and macroeconomic fundamentals for six major industrialized countries in the wake of the recent financial crisis. Our analysis is based on a structural vector autoregressive (SVAR) model, which relies on a long-run restriction to identify fundamental and non-fundamental shocks to stock prices. This paper is the first in this line of literature to formally test the identifying restriction. We do so by means of a Markov switching-SVAR (MS-SVAR) model in heteroskedasticity. We generally find that it is supported by the data. Our structural analysis shows that after the 2008 financial crisis, stock prices tend to fall in line with their fundamentals for all six countries investigated. In general, we observe a self-correction of stock prices towards their fundamental values.