Extrapolative Expectations, Corporate Activities, and Asset Prices

This paper studies how extrapolative expectations affect corporate activities and asset prices. Empirically, an increase in misperception on earnings growth, a firm-level proxy for extrapolation, is associated with an increase in investment, debt and equity issuance, and bond and stock prices in the short term, but is predictive of a decline in all activities and prices in the long term. This pattern is more pronounced among financially constrained firms. Theoretically, I build a firm dynamics model with extrapolative expectations and financial frictions, and show that the interaction between these two frictions is crucial in explaining the empirical findings. Intuitively, after a sequence of favorable shocks, agents extrapolate and become overoptimistic about future productivity. Firms invest and borrow more in the short term. A lower perceived default probability improves financing conditions, further increasing investment and borrowing. Future realizations then turn out worse than expected, subjecting real and financial activities and asset prices to predictable reversals in the long term.