Natural Expectations, Macroeconomic Dynamics, and Asset Pricing
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How does an economy behave if (1) fundamentals are truly hump-shaped, exhibiting momentum in the short run and partial mean reversion in the long run, and (2) agents do not know that fundamentals are hump-shaped and base their beliefs on parsimonious models that they fit to the available data? A class of parsimonious models leads to qualitatively similar biases and generates empirically observed patterns in asset prices and macroeconomic dynamics. First, parsimonious models will robustly pick up the short-term momentum in fundamentals but will generally fail to fully capture the long-run mean reversion. Beliefs will therefore be characterized by endogenous extrapolation bias and procyclical excess optimism. Second, asset prices will be highly volatile and exhibit partial mean reversion—that is, overreaction. Excess returns will be negatively predicted by lagged excess returns, P/E ratios, and consumption growth. Third, real economic activity will have amplified cycles. For example, consumption growth will be negatively auto-correlated in the medium run. Fourth, the equity premium will be large. Agents will perceive that equities are very risky when in fact long-run equity returns will co-vary only weakly with long-run consumption growth. If agents had rational expectations, the equity premium would be close to zero. Fifth, sophisticated agents—that is, those who are assumed to know the true model—will hold far more equity than investors who use parsimonious models. Moreover, sophisticated agents will follow a countercyclical asset allocation policy. These predicted effects are qualitatively confirmed in US data.
We are grateful to Daron Acemoglu, Nicholas Barberis, John Beshears, Markus Brunnermeier, John Campbell, James Choi, Larry Christiano, John Driscoll, Emmanuel Farhi, Kenneth French, Xavier Gabaix, Stefano Giglio, Lars Peter Hansen, Blake LeBaron, Greg Mankiw, Joshua Schwartzstein, Andrei Shleifer, Jeremy Stein, Jim Stock, Michael Woodford, our discussants Marty Eichenbaum and George Evans, and seminar/conference participants for helpful comments and discussions. We are indebted to Brendan Price and Fernando Yu for excellent research assistance. David Laibson acknowledges support from the NIA (P01AG005842).
I have received honoraria for speaking about my academic research at the following private and government organizations:
2011: ANZ, Blackrock, Express Scripts*** (member Scientific Advisory Board), Morningstar
2010: Blackrock, Express Scripts** (member Scientific Advisory Board), Financial Advisers to U.S. Armed Forces Service Members, Financial Planning Association, Merrill Lynch, MetLife, North American Securities Administrators Association (investor protection association comprised of state securities regulators), Pioneer*
2009: AARP, Barclays Global Investors, Express Scripts (member Scientific Advisory Board), Fidelity, Mackenzie, MassMutual, Pioneer*
2008: American Institute of Certified Public Accountants, Alliance Bernstein, Barclays Global Investors, Express Scripts (Scientific Advisory Board), Financial Advisers to U.S. Armed Forces Service Members, MetLife, Pioneer*
2007: AARP, Barclays Global Investors, BP, Citigroup, European Commission, Fidelity, Pioneer*
*Keybridge Research arranged my talks at Pioneer.
**All payments donated to charitable organizations.
***All payments donated directly by Express Scripts to charitable organizations.