Structural Breaks, Incomplete Information and Stock Prices

This paper presents new empirical evidence on the existence of structural breaks in the fundamentals process underlying US stock prices and develops an asset pricing model which considers the possibility of such breaks. Three break points are identified: The Great Depression, World War II, and the oil price shocks around 1974. Different hypotheses for how investors form expectations about future dividends after a break are proposed and analysed. A model in which investors do not have full information about the parameters of the dividend process but gradually update their beliefs as new information arrives is shown to induce volatility clustering and serially correlated stock returns after a break. These patterns are confirmed to exist in US stock returns around the time of the breakpoints.