Beliefs-Driven Price Association

41 Pages Posted: 20 Jun 2015 Last revised: 24 Jul 2015

See all articles by Paul E. Fischer

Paul E. Fischer

University of Pennsylvania - Accounting Department

Mirko Stanislav Heinle

University of Pennsylvania - Accounting Department

Robert E. Verrecchia

University of Pennsylvania - Accounting Department

Date Written: July 13, 2015

Abstract

In addition to being a function of traditional fundamentals such as cash-flow persistence and the discount rate, the equilibrium association between a security price and a value-relevant statistic can simply be a function of what rational investors believe the association will be. We refer to this phenomenon as beliefs-driven price association (BPA). By explicitly considering the phenomenon of BPA, we show that the price response to information releases can vary over time even if the risk-free interest rate and investor preferences are static and the earnings/cash flow generating process is stable. This observation suggests, for example, that price-to-earnings associations and price volatility can vary over time even if a stable pattern of economic fundamentals suggests otherwise. The possibility of BPA suggests that measures of the cost of capital, information content, and growth prospects inferred from observed market prices will be confounded. While we do not predict when periods of BPA will arise, we provide empirically testable predictions about how prices should behave during periods of BPA. In particular, we predict that, during sufficiently long periods of high (positive or negative) BPA, price volatility, price levels, and expected returns will be higher than would be implied by a fundamental valuation framework. Finally, while BPA in the pricing of one security does not cause BPA in the pricing of other securities, the price levels of those other securities will be affected if the securities with BPA are sufficiently large relative to the market as a whole.

Keywords: Higher-Order-Beliefs, Earnings Response, Price Volatility, Pricing Bubbles

JEL Classification: G12, M41

Suggested Citation

Fischer, Paul E. and Heinle, Mirko Stanislav and Verrecchia, Robert E., Beliefs-Driven Price Association (July 13, 2015). Forthcoming in Journal of Accounting & Economics (JAE). Available at SSRN: https://ssrn.com/abstract=2620405 or http://dx.doi.org/10.2139/ssrn.2620405

Paul E. Fischer

University of Pennsylvania - Accounting Department ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

Mirko Stanislav Heinle (Contact Author)

University of Pennsylvania - Accounting Department ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

Robert E. Verrecchia

University of Pennsylvania - Accounting Department ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States
215-898-6976 (Phone)
215-573-2054 (Fax)

Register to save articles to
your library

Register

Paper statistics

Downloads
152
Abstract Views
1,579
rank
191,138
PlumX Metrics