Long Term Expectations and Aggregate Fluctuations
In line with Keynes’ intuition, volatility in the stock market and in real economic activity are linked by expectations of long term profits. We show that analysts’ optimism about the long term earnings growth of S&P 500 firms is associated with a near term boom in major US financial markets, real investment, and other business cycle indicators. The same optimism however predicts disappointing earnings growth and a contraction in financial markets and real activity one to two years later. Overreaction of measured long term profit expectations emerges as a promising mechanism for reconciling Shiller’s excess volatility puzzle with the business cycle.
We thank our discussants Venky Venkateswaran and George-Marios Angeletos for very helpful comments, and to Lawrence Christiano for providing some data we use in the analysis. We also thank the Chae Family Economics Research Fund at Harvard University for financial support of this research. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.