Long Term Expectations and Aggregate Fluctuations
In line with Keynes’ intuition, stock market volatility and real economic activity are linked by expectations of long term profits. Using data on analysts’ expectations of earnings growth of S&P 500 firms, LTG, we show that current long term optimism is associated with a near term boom in major US financial markets, real investment, and other business cycle indicators. LTG optimism then jointly predicts disappointing earnings growth and a contraction in financial markets and real activity one to two years later. Overreaction of long term profit expectations emerges as a promising mechanism for reconciling Shiller’s excess volatility puzzle with the business cycle.