Working Paper: CEPR ID: DP9988
Authors: Klaus Adam; Johannes Beutel; Albert Marcet
Abstract: The booms and busts in U.S. stock prices over the post-war period can to a large extent be explained by fluctuations in investors` subjective capital gains expectations. Survey measures of these expectations display excessive optimism at market peaks and excessive pessimism at market throughs. Formally incorporating subjective price beliefs into an otherwise standard asset pricing model with utility maximizing investors, we show how subjective belief dynamics can temporarily delink stock prices from their fundamental value and give rise to asset price booms that ultimately result in a price bust. The model successfully replicates (1) the volatility of stock prices and (2) the positive correlation between the price dividend ratio and expected returns observed in survey data. We show that models imposing objective or `rational` price expectations cannot simultaneously account for both facts. Our findings imply that large parts of U.S. stock price fluctuations are not due to standard fundamental forces, instead result from self-reinforcing belief dynamics triggered by these fundamentals.
Keywords: asset prices; subjective beliefs; survey data
JEL Codes: D84; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| past capital gains (H24) | future expectations (D84) |
| positive surprises in capital gains expectations (P17) | increased stock demand (J23) |
| increased stock demand (J23) | higher prices (D49) |
| fluctuations in subjective expectations (D84) | deviations of stock prices from fundamental values (G17) |
| investor optimism (G31) | price booms (Q33) |
| optimism reaches a threshold (E32) | wealth effect (E21) |
| wealth effect (E21) | price bust (E32) |
| past capital gains (H24) | current stock prices (G13) |
| price-dividend ratio (G35) | expected returns (G17) |
| self-reinforcing belief dynamics (D83) | stock price fluctuations (G17) |