Abstract: To address the excess volatility puzzle—the excessive movement in stock prices—researchers often use variance decompositions of stock price ratios, where stock prices are scaled by fundamental measures. We demonstrate that stock price ratios based on fundamental measures with high transitory volatility, such as commonly used earnings measures, are not informative about movements in stock prices. To overcome this, we propose using Street earnings to construct the price-to-earnings ratio. Street earnings, calculated before transitory items, offer a more informative and persistent measure of future fundamentals. Since the Street price-earnings ratio extracts variation in stock prices and returns, its use is highly informative in asset pricing tests. Accordingly, we show that the Street priceearnings ratio has more in- and out-of-sample explanatory power for predicting returns than other valuation ratios. Additionally, we reconcile conflicting views on which subjective expectations drive stock price movements, finding that expectations of short-term earnings growth, long-term earnings growth, and returns can all help explain the excess volatility puzzle.
