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Expectations of Fundamentals and Stock Market Puzzles
Room 408, Università della Svizzera italiana, Campus Lugano
Full professor of Finance, Bocconi University
We revisit leading puzzles about the aggregate stock market by incorporating into a standard present value framework the survey expectations of earnings for S&P 500 firms. Taking survey expectations into account, while keeping discount rates constant, explains a significant part of: i) “excess” stock price volatility, ii) price-earnings ratio variation, and iii) return predictability. These results are consistent with a mechanism in which good news about fundamentals lead to excessively optimistic forecasts earnings, in particular long-term forecasts, which inflates stock prices and leads to subsequent low returns. Relaxing rational expectations of fundamentals in a standard asset pricing model helps account for stock market anomalies in a parsimonious way.