Working Paper: NBER ID: w27283
Authors: Pedro Bordalo; Nicola Gennaioli; Rafael La Porta; Andrei Shleifer
Abstract: We construct an index of long term expected earnings growth for S&P500 firms and show that it has remarkable power to jointly predict errors in these expectations and stock returns, in both the aggregate market and the cross section. The evidence supports a mechanism whereby good news cause investors to become too optimistic about earnings growth, for the market as a whole but especially for specific firms. This leads to inflated stock prices and, as beliefs are systematically disappointed, to subsequent low returns in the aggregate market and for specific firms in the cross section. Overreaction of measured long-term expectations helps resolve major asset pricing puzzles without time series or cross-sectional variation in required returns.
Keywords: belief overreaction; stock market; earnings growth; asset pricing
JEL Codes: G02; G12; G4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Upward revisions in long-term earnings growth expectations (O49) | Inflated stock prices (E31) |
| Inflated stock prices (E31) | Systematic disappointment in earnings growth (P17) |
| Systematic disappointment in earnings growth (P17) | Low future returns (G17) |
| High current expectations of long-term earnings growth (D25) | Lower future aggregate stock returns (G17) |
| Periods of excess optimism (E32) | Low returns (G19) |
| Forecast errors in earnings growth (G17) | Return predictability (C53) |