Fear of Recessions, Heterogenous Beliefs, and Stock Price Under/Over-Reaction

Abstract:     
Our purpose is to show how large difference of beliefs induced by the fear of a recession is amenable to large and persistent price responses to contemporaneous shocks. We construct a pure exchange economy populated by two agents who estimate strictly different models regarding the fundamental. In particular, one agent believes that recessions could occur whereas the second agent has smoother beliefs. We show that this setting is prone to generate disagreement whose persistence varies over a bearish phase. When economic conditions start to deteriorate, disagreement among agents significantly increases in a persistent fashion. Yet, after a sustained streak of bad news, disagreement gradually loses of its persistence. Contrary to the common wisdom that heterogeneous beliefs lead to large bets, we show that this pattern in disagreement ultimately causes the trading volume to dry up. As a result, price sensitivity to current shocks, along with persistence, is shown to be dramatically increased when compared with a model absent of heterogeneous beliefs, but with perceived recession risk. Using Google search data, we find empirical support for the main implication of the model.

Number of Pages in PDF File: 64

Keywords: Price Under/Over-Reaction, Recessions, Fear, Heterogenous Beliefs, Price Pressures, Malliavin Calculus

JEL Classification: D50, D51, D58, D83, D84, E31, E32, E37, G12

working papers series