Contrarians, Extrapolators, and Stock Market Momentum and Reversal

Abstract

We document considerable cross-sectional variation in survey expectations about aggregate stock market returns. While most investors are extrapolators who expect higher returns after a good performance, some are contrarians. More notably, compared to extrapolators, contrarians have less persistent expectations that are corrected more quickly. Accordingly, we develop a dynamic equilibrium model accounting for these differences and find that the equilibrium stock price exhibits short-term momentum and long-term reversal as in the data. We also test key predictions of the model that link short-term momentum to differences among extrapolators and contrarians and find supportive evidence for our mechanism.

Keywords: Extrapolative expectations, extrapolators, autocorrelation, momentum, reversal

JEL Classification: G11, G12