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Fundamental factors and extrapolation in stock-market expectations: The central role of structural change

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  • Frydman, Roman
  • Stillwagon, Joshua R.

Abstract

Rational expectations and behavioral-finance models are widely interpreted as representing two distinct conceptions of decision-making: rational and irrational, respectively. Using survey data, this paper presents econometric evidence that both fundamental factors and extrapolation drive participants’ expectations of stock returns, but that they do so in ways that vary over time. Although both the REH and behavioral-finance approaches offer relevant insights for understanding participants’ expectations, neither of these distinct model classes is consistent with time-series data. The paper’s findings also suggest that structural change gives rise to ambiguity about the correct quantitative model driving outcomes. This ambiguity, faced by economists and market participants alike, is the key to according both fundamental and behavioral factors a role in rational forecasting.

Suggested Citation

  • Frydman, Roman & Stillwagon, Joshua R., 2018. "Fundamental factors and extrapolation in stock-market expectations: The central role of structural change," Journal of Economic Behavior & Organization, Elsevier, vol. 148(C), pages 189-198.
    • Handle: RePEc:eee:jeborg:v:148:y:2018:i:c:p:189-198
    DOI: 10.1016/j.jebo.2018.02.017
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    Cited by:

    1. Lansing, Kevin J. & LeRoy, Stephen F. & Ma, Jun, 2022. "Examining the sources of excess return predictability: Stochastic volatility or market inefficiency?," Journal of Economic Behavior & Organization, Elsevier, vol. 197(C), pages 50-72.
    2. Beckmann, Joscha & Czudaj, Robert L., 2020. "Fundamental determinants of exchange rate expectations," VfS Annual Conference 2020 (Virtual Conference): Gender Economics 224617, Verein für Socialpolitik / German Economic Association.
    3. Josh Stillwagon & Peter Sullivan, 2020. "Markov switching in exchange rate models: will more regimes help?," Empirical Economics, Springer, vol. 59(1), pages 413-436, July.

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    More about this item

    Keywords

    Automatic model selection; Asset-market expectations; REH; Behavioral finance; Structural change; Model ambiguity;
    All these keywords.

    JEL classification:

    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • G41 - Financial Economics - - Behavioral Finance - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making in Financial Markets
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation

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