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Applied Financial Economics, 1999, 9, 129-142
A multi-country analysis of the temporary
and permanent components of stock prices
LIAM A. GALLAGHER
Department of Economics, University College^ Cork, Ireland
The paper investigates the mean-reverting components in real stock prices for 16
countries. The temporary and permanent components of real stock prices are identi-
lied through appropriate restrictions on a vector autoregression of real stock returns
and inflation. The multivariate time series technique identifies the size and significance
of the mean-reverting component. The evidence supports the mean-reversion hypoth-
esis that stock prices are not random walks. A significant temporary component in
real stock prices of magnitude between 7 and 64Vo of the variation of quarterly real
stock price movements is found. For a number of countries there is evidence of
persistence in the temporary component.
I. INTRODUCTION 1997), markets other than the US have been neglected,
principally because of the unavailability of high quality
The random walk hypothesis that returns are unpredictable non-overlapping long time series for stock prices that tradi-
and that stock prices follow a random walk or martingale tional techniques require.
process (Granger and Morgenstern, 1963; Fama, 1965) is In this paper we measure the size and significance of the
probably the most well-researched topic in the empirical temporary (or mean-reverting) and permanent components
literature on financial economics, dating back at least to of real stock prices for 16 stock markets. We employ a multi-
Cowles and Jon