Extracting Extrapolative Beliefs from Market Prices: An Augmented Present-Value Approach

75 Pages Posted: 18 May 2021 Last revised: 15 Nov 2021

See all articles by Stefano Cassella

Stefano Cassella

Tilburg University- School of Economics and Management

Huseyin Gulen

Purdue University - Krannert School of Management

Yan Liu

Purdue University

Date Written: May 17, 2021

Abstract

This paper proposes a latent-variables approach to recover biases in beliefs directly from asset prices. We focus on return extrapolation, a bias in expectations formation that has received considerable attention in recent asset pricing research. We estimate a present-value model of the price-dividend ratio of the market that embeds extrapolative beliefs alongside discount rates and expected dividend growth. This approach allows us to measure extrapolation bias without having to rely on survey data and inherently guarantees that the researcher focuses on a set of beliefs that matter for price formation. We use our 70-year long time-series of extrapolative beliefs to test the key prediction of behavioral models of the stock market with return extrapolators, namely, that a rise in extrapolation bias today leads to predictably lower market returns in the future. Through both in-sample and out-of-sample analysis, our results provide support for behavioral theories of asset prices in the presence of extrapolators.

Keywords: Present value, Structural estimation, Expectations formation, Extrapolation bias, Behavioral, Sentiment, Predictive regression, Discount rate, Dividend growth

JEL Classification: G12, G17, G41

Suggested Citation

Cassella, Stefano and Gulen, Huseyin and Liu, Yan, Extracting Extrapolative Beliefs from Market Prices: An Augmented Present-Value Approach (May 17, 2021). Available at SSRN: https://ssrn.com/abstract=3847527 or http://dx.doi.org/10.2139/ssrn.3847527

Stefano Cassella

Tilburg University- School of Economics and Management ( email )

Professor de Moorplein 521
Tilburg, 5037
Netherlands

Huseyin Gulen (Contact Author)

Purdue University - Krannert School of Management ( email )

1310 Krannert Building
West Lafayette, IN 47907-1310
United States

Yan Liu

Purdue University ( email )

West Lafayette, IN 47907-1310
United States

HOME PAGE: http://yliu1.com

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