Which Subjective Expectations Explain Asset Prices?

Abstract

We present a method for determining whether errors in expectations explain asset pricing puzzles without imposing assumptions about the mechanism of the error. Using accounting identities and survey forecasts, we find that errors in expected long-term inflation and short-term nominal earnings growth explain price variation, return predictability, and the rejection of the expectations hypothesis for aggregate stock and bond markets. Errors in expected short-term inflation and long-term nominal earnings growth play no role. The relevant errors are consistent with mistakes about both the persistence of forecasted variables and the response to surprises. A fundamental extrapolation model successfully replicates these findings.

Keywords: subjective expectations, inflation expectations, subjective term structure, fundamental extrapolation, expectations hypothesis

JEL Classification: G40, G12, G14, E71