New Tests of Expectation Formation with Applications to Asset Pricing Models

Abstract

The paper develops new tests of expectation formation which are generally applicable in …nancial and macroeconomic models. The tests utilize cointegration restrictions among forecasts of model variables. Survey data suggests forecasts of stock prices are not cointegrated with forecasts of consumption and rejects this aspect of the formation of stock price expectations in a wide range of asset pricing models, including rational expectations and various learning or sentiment-based models. We show adding sentiment (or judgment) directly to subjective stock price forecasts can reconcile equity pricing models with the new survey evidence.