Expectations of Fundamentals and Stock Market Puzzles
We revisit several leading puzzles about the aggregate stock market by incorporating into a standard dividend discount model survey expectations of earnings of S&P 500 firms. Using survey expectations, while keeping discount rates constant, explains a significant part of “excess” stock price volatility, price-earnings ratio variation, and return predictability. The evidence is consistent with a mechanism in which good news about fundamentals leads to excessively optimistic forecasts of earnings, especially at long horizons, which inflate stock prices and lead to subsequent low returns. Relaxing rational expectations of fundamentals in a standard asset pricing model accounts for stock market anomalies in a parsimonious way.
Gennaioli thanks the European Research Council for Financial Support under the ERC Consolidator Grant. We are grateful to Nick Barberis, Francesca Bastianello, John Campbell, Kent Daniel, Paul Fontanier, Spencer Kwon, Yueran Ma, Peter Maxted, Dev Patel, Jesse Shapiro, and Adi Sunderam for extremely helpful comments. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.