Extracting Extrapolative Beliefs from Market Prices: An Augmented Present-Value Approach

Abstract

This paper proposes a latent-variables approach to recover biases in beliefs directly from asset prices. We focus on return extrapolation, a bias in expectations formation that has received considerable attention in recent asset pricing research. We estimate a present-value model of the price-dividend ratio of the market that embeds extrapolative beliefs alongside rational discount rates and expected dividend growth. This approach allows us to measure extrapolation bias without having to rely on survey data, and inherently guarantees that the researcher focuses on a set of beliefs that matter for price formation. We use our 70-year long time-series of extrapolative beliefs to test the key prediction of behavioral models of the stock market with return extrapolators, namely, a rise in extrapolation bias today leads to predictably lower market returns in the future. Through both in-sample and out-of-sample analysis, our results provide support for behavioral theories of asset prices in the presence of extrapolators.