Belief Overreaction and Stock Market Puzzles

Abstract

We construct an index of long term expected earnings growth for S&P500 firms and show that it has remarkable power to jointly predict errors in these expectations and stock returns, in both the aggregate market and the cross section. The evidence supports a mechanism whereby good news cause investors to become too optimistic about earnings growth, for the market as a whole but especially for specific firms. This leads to inflated stock prices and, as beliefs are systematically disappointed, to subsequent low returns in the aggregate market and for specific firms in the cross section. Overreaction of measured long-term expectations helps resolve major asset pricing puzzles without time series or cross-sectional variation in required returns. in long run risk, or in disaster risk are hard to measure. Here we pursue an orthogonal approach: we keep required returns constant and relax rational expectations of fundamentals. We discipline departures from rationality using data on analyst expectations of future earnings growth of listed firms. We show that expectations of long