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Stock Price Booms and Expected Capital Gains

  • Klaus Adam
  • Johannes Beutel
  • Albert Marcet

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 be- lief dynamics can temporarily de-link 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 part of U.S. stock price fluctuations are not due to standard fundamental forces, instead result from self-reinforcing belief dynamics triggered by these fundamentals.

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Paper provided by Barcelona Graduate School of Economics in its series Working Papers with number 757.

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Date of creation: Jan 2014
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Handle: RePEc:bge:wpaper:757
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  1. Philippe Bacchetta & Elmar Mertens & Eric van Wincoop, 2006. "Predictability in Financial Markets: What Do Survey Expectations Tell Us?," Working Papers 06.04, Swiss National Bank, Study Center Gerzensee.
  2. Hassan, Tarek & Mertens, Thomas M., 2014. "The Social Cost of Near-Rational Investment," CEPR Discussion Papers 10007, C.E.P.R. Discussion Papers.
  3. Pontus Rendahl, 2013. "Inequality Constraints and Euler Equation based Solution Methods," Cambridge Working Papers in Economics 1320, Faculty of Economics, University of Cambridge.
  4. Aruoba, S. Boragan & Fernandez-Villaverde, Jesus & Rubio-Ramirez, Juan F., 2006. "Comparing solution methods for dynamic equilibrium economies," Journal of Economic Dynamics and Control, Elsevier, vol. 30(12), pages 2477-2508, December.
  5. Andreas Fuster & Benjamin Hebert & David Laibson, 2011. "Natural Expectations, Macroeconomic Dynamics, and Asset Pricing," NBER Working Papers 17301, National Bureau of Economic Research, Inc.
  6. Fama, Eugene F. & French, Kenneth R., 1988. "Dividend yields and expected stock returns," Journal of Financial Economics, Elsevier, vol. 22(1), pages 3-25, October.
  7. Robin Greenwood & Stefan Nagel, 2008. "Inexperienced Investors and Bubbles," NBER Working Papers 14111, National Bureau of Economic Research, Inc.
  8. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
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