TY - JOUR AU - Cochrane,John H. AU - Longstaff,Francis A. AU - Santa-Clara,Pedro TI - Two Trees: Asset Price Dynamics Induced by Market Clearing JF - National Bureau of Economic Research Working Paper Series VL - No. 10116 PY - 2003 Y2 - November 2003 UR - http://www.nber.org/papers/w10116 L1 - http://www.nber.org/papers/w10116.pdf N1 - Author contact info: John H. Cochrane Booth School of Business University of Chicago 5807 S. Woodlawn Chicago, IL 60637 Tel: 773/702-3059 Fax: 773/702-0458 E-Mail: john.cochrane@chicagobooth.edu Francis Longstaff UCLA Anderson Graduate School of Management 110 Westwood Plaza, Box 951481 Los Angeles, CA 90095-1481 Tel: 310/825-2218 Fax: 310/206-5455 E-Mail: francis.longstaff@anderson.ucla.edu Pedro Santa-Clara Faculdade de Economia Universidade Nova de Lisboa Rua Marques de Fronteira, 20 1099-038 LISBOA PORTUGAL Tel: +351-91-493-4313 E-Mail: psc@fe.unl.pt AB - If stocks go up, investors may want to rebalance their portfolios. But investors cannot all rebalance. Expected returns may need to change so that the average investor is still happy to hold the market portfolio despite its changed composition. In this way, simple market clearing can give rise to complex asset market dynamics. We study this phenomenon in a very simple model. Our model has two Lucas trees.' Each tree has i.i.d.dividend growth, and the representative investor has log utility. We are able to give analytical solutions to the model. Despite this simple setup, price-dividend ratios, expected returns, and return variances vary through time. A dividend shock leads to underreaction' in some states, as expected returns rise and prices slowly adjust, and overreaction' in others. Expected returns and excess returns are predictable by price-dividend ratios in the time series and in the cross section, roughly matching value effects and return forecasting regressions. Returns generally display positive serial correlation and negative cross-serial correlation, leading to 'momentuem,' but the opposite signs are possible as well. A shock to one asset's dividend a.ects the price and expected return of the other asset, leading to substantial correlation of returns even when there is no correlation of cash flows and giving the appearance of contagion.' Market clearing allows the inverse portfolio' problem to be solved, in which the weights of the assets in the market portfolio are inverted' to solve for the parameters of the assets' return generating process. ER -