Different Extrapolators and Stock Market Momentum and Reversal

Abstract

Using survey data, we document significant differences in investors' extrapolative expectations about future stock market returns. Namely, there are both negative and positive extrapolators. Compared to positive extrapolators, negative extrapolators are fewer in numbers but put relatively more weight on the recent stock returns when forming their expectations. Accordingly, we develop a dynamic equilibrium model that accounts for these differences in investors’ extrapolative expectations. In the model, the equilibrium stock price exhibits short-term momentum and long-term reversal as in the data. We also test the key predictions of the model and find supportive evidence for the model mechanism.

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

JEL Classification: G11, G12