Cointegration and stock prices: The random walk on wall street revisited

Abstract One of the more famous and empirically regular instances of unit roots occurs in stock price series, where they are consistent with rational expectations and efficient markets under certain assumptions. In this paper we investigate the dynamic behavior of five stock prices over the volatile period from January 1972 through December 1979, finding that the series are cointegrated with one dominant common trend, a component with an estimated root of 0.95. In addition, we find a lesser trend and two complex roots in the cycle model. These findings are validated by out-of-sample forecasts beginning in January 1980. In addition to mean squared error criteria, the forecasts are evaluated nonparametrically in two separate applications of a test due to Henriksson and Merton.