Extrapolation Bias and the Predictability of Stock Returns by Price-Scaled Variables

Cassella, Stefano; Gulen, Huseyin

doi:10.1093/rfs/hhx139

Cited by 96 publications

(30 citation statements)

References 62 publications

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“…This is because lower autocorrelation in the pricedividend ratio strengthens the negative relationship between the current price-dividend ratio and next-year returns, following equation ( 1). Thus, the model is able to simultaneously replicate the findings on return expectations from Greenwood and Shleifer (2014) and Cassella and Gulen (2018) on top of our findings on cash flow growth expectations.…”

Section: Dynamics Of Expectations and Price Ratiossupporting

confidence: 67%

“…Third, the model generates predictable forecast errors for cash flow growth expectations in the pre-2003 sample but not in the 2003 to 2015 sample, in line with what we find in Section III.B and offering a potential explanation for why this occurs. Interestingly, the model also generates two of the findings of the return extrapolation literature, namely, that return expectations are more correlated with current returns than future returns (Greenwood and Shleifer (2014)) and that the ability of the price-dividend ratio to predict next-year returns is stronger when return expectations are more related to recent returns than earlier returns (Cassella and Gulen (2018)).…”

Section: B2 Distribution-independent Resultsmentioning

confidence: 79%

“…In the model, return expectations are more correlated with current returns than with future returns, asGreenwood and Shleifer (2014) document, and the ability of the price-dividend ratio to predict future returns is stronger when return expectations are more related to recent returns than earlier returns, asCassella and Gulen (2018) find.…”

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confidence: 76%

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Subjective Cash Flow and Discount Rate Expectations

O¹,

Myers²

2021

The Journal of Finance

124

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Why do stock prices vary? Using survey forecasts, we find that cash flow growth expectations explain most movements in the S&P 500 price-dividend and price-earnings ratios, accounting for at least 93% and 63% of their variation. These expectations comove strongly with price ratios, even when price ratios do not predict future cash flow growth. In comparison, return expectations have low volatility and small comovement with price ratios. Short-term, rather than long-term, expectations account for most price ratio variation. We propose an asset pricing model with beliefs about earnings growth reversal that accurately replicates these cash flow growth expectations and dynamics.A CENTRAL QUESTION IN FINANCE IS WHAT drives stock price movements. Specifically, researchers want to know what explains the large movements in the aggregate price-dividend ratio, a measure of how cheap or expensive stocks are at a given time. Based on the present value approach, for any investor that prices the stock, the stock's price should equal her expected discounted value of future dividends. This is true whether her expectations match an objective probability distribution or they come from a subjective distribution. Price changes should therefore be due to changes in her dividend expectations or her return expectations, and changes in the price-dividend ratio should be due to changes in her dividend growth expectations or return expectations.The challenge is determining the expectations of market participants. If investors have rational expectations, then we can infer the importance of

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Section: Dynamics Of Expectations and Price Ratiossupporting

confidence: 67%

Section: B2 Distribution-independent Resultsmentioning

confidence: 79%

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Subjective Cash Flow and Discount Rate Expectations

O¹,

Myers²

2021

The Journal of Finance

124

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“…This exponential decay specification has been previously estimated by Greenwood and Shleifer (2014), Barberis et al (2015), and Cassella and Gulen (2018), using aggregate 10 The Forcerank data only measure return expectations over one week, a short forecasting horizon. As a result, a concern is that our data are not helpful for understanding investor beliefs over longer horizons (such as six months or one year).…”

Section: Exponential Decay Modelmentioning

confidence: 99%

Extrapolative beliefs in the cross-section: What can we learn from the crowds?

Huang

Jin

2021

Journal of Financial Economics

120

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This is a PDF file of an article that has undergone enhancements after acceptance, such as the addition of a cover page and metadata, and formatting for readability, but it is not yet the definitive version of record. This version will undergo additional copyediting, typesetting and review before it is published in its final form, but we are providing this version to give early visibility of the article. Please note that, during the production process, errors may be discovered which could affect the content, and all legal disclaimers that apply to the journal pertain.

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“…The value of θ is initially set at 0.8, consistent with the estimation by Cassella and Gulen (2018). We assume that investors start with a wealth level of 100 and Q = 1/2.…”

Section: The Setupmentioning

confidence: 99%

Price and Volume Dynamics in Bubbles

2018

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We propose a framework to explain the sharp rise in prices and volume observed in historical financial bubbles. The model generates a novel mechanism for volume: due to the interaction between beliefs and preferences, investors are quick to buy assets with positive past returns, but also quick to sell them if the good returns continue.Using account-level transaction data on the 2014-2015 Chinese stock market bubble, we test the model's predictions about volume and find supportive evidence. We also empirically show that, consistent with the model, extrapolators are largely responsible for the price run-up and crash during the bubble. * Peng is indebted to Nick Barberis, James Choi, Will Goetzmann, and Kelly Shue for guidance and encouragement. For helpful comments, we thank Jiangze Bian,

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Extrapolation Bias and the Predictability of Stock Returns by Price-Scaled Variables

Cited by 96 publications

References 62 publications

Subjective Cash Flow and Discount Rate Expectations

Subjective Cash Flow and Discount Rate Expectations

Extrapolative beliefs in the cross-section: What can we learn from the crowds?

Price and Volume Dynamics in Bubbles

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