What Moves Prices? The Dynamics of Fundamentals and Returns

We propose a dynamic model that explains a large share of both in-sample and out-of-sample variation in the annual return and growth of fundamentals on the aggregate S&P 500 index. To capture the time variation in investors' beliefs, we rely on a penalized vector autoregressive model and predictors that summarize a substantial portion of the information available in the market. We combine 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 time-varying expected returns account for most of the movements in the price-to-dividend ratio over the period 1980–2021, but play a smaller role in the price-to-earnings ratio. Notably, over the period 2001–2021, the expected growth of fundamentals explains a significantly larger share of the variation in both valuation ratios.