Asset Pricing Under Keeping Up with the Joneses and Time-Varying Sentiment

Abstract

This paper studies the joint effect of “Keeping up with the Joneses” (KUJ) preferences,
time-varying sentiment, and average pessimism in a two-agent equilibrium asset pricing
model. We find that although the irrational agent does not survive in the long run, due to KUJ,
sentiment continues to have a significant effect on market equilibrium. In particular, the model
generates a procyclical price-dividend ratio, excess countercyclical stock volatility, and a large
countercyclical equity premium, which are consistent with empirical observations. Moreover,
the term-structure of real interest rates is upward (resp. downward) sloping when the short rate
is relatively low (resp. high).

Keywords: keeping up with the Joneses; sentiment; equity premium; excess volatility; yield curve

JEL Classification: G12, D84