Contrarians, Extrapolators, and Stock Market Momentum and Reversal

Abstract

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

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

JEL Classification: G11, G12