Extracting extrapolative beliefs from market prices: An augmented present-value approach

Abstract

We propose a latent-variables approach to recover extrapolative beliefs from asset prices. We estimate a present-value model of the price–dividend ratio of the market that embeds both return extrapolation and cash-flow extrapolation, alongside discount rates and rational expectations of dividend growth. This approach allows us to measure extrapolation bias without having to rely on survey data, and it inherently guarantees that the researcher focuses on a set of beliefs that matter for price formation. We show that extrapolative beliefs extracted from prices are highly correlated with surveys and that survey-based and price-based extrapolative beliefs share similar predictive properties for future returns, with the former improving upon the latter.