Which Subjective Expectations Explain Asset Prices?

Author:

De la O Ricardo1,Myers Sean2

Affiliation:

1. Marshall School of Business, University of Southern California , USA

2. The Wharton School at the University of Pennsylvania , USA

Abstract

Abstract We present a method for determining whether errors in expectations explain asset pricing puzzles without imposing assumptions about the error mechanism. Using accounting identities and survey forecasts, we find that errors in expected long-term inflation explain price variation, return predictability, and the rejection of the expectations hypothesis for aggregate stock and bond markets. Errors in short-term (long-term) nominal earnings growth expectations explain (do not explain) stock price variation and return predictability. The relevant errors are consistent with mistakes about the persistence of forecasted variables and the response to surprises. A simple framework based on fundamental extrapolation successfully replicates these findings. (JEL G40, G12, G14, E71)

Publisher

Oxford University Press (OUP)

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