Subjective Cash Flow and Discount Rate Expectations

Abstract

Why do stock prices vary? Using survey forecasts, we find that cash flow growth expectations explain most movements in the S&P 500 price-dividend and price-earnings ratios, accounting for at least 93% and 63% of their variation. These expectations comove strongly with price ratios, even when price ratios do not predict future cash flow growth. In comparison, return expectations have low volatility and small comovement with price ratios. Short-term, rather than long-term, expectations account for most price ratio variation. We propose an asset pricing model with beliefs about earnings growth reversal that accurately replicates these cash flow growth expectations and dynamics.A CENTRAL QUESTION IN FINANCE IS WHAT drives stock price movements. Specifically, researchers want to know what explains the large movements in the aggregate price-dividend ratio, a measure of how cheap or expensive stocks are at a given time. Based on the present value approach, for any investor that prices the stock, the stock's price should equal her expected discounted value of future dividends. This is true whether her expectations match an objective probability distribution or they come from a subjective distribution. Price changes should therefore be due to changes in her dividend expectations or her return expectations, and changes in the price-dividend ratio should be due to changes in her dividend growth expectations or return expectations.The challenge is determining the expectations of market participants. If investors have rational expectations, then we can infer the importance of

Asset pricing with return extrapolation

“…4 Given this, a Campbell-Shiller decomposition using the agent's subjective expectations about stock market returns and dividend growth shows that changes in subjective expectations about future dividend growth explain 110% of the variance of the pricedividend ratio, while changes in subjective return expectations explain -10% of the variance of the price-dividend ratio. This quantitatively matches the recent empirical findings of De la O and Myers (2021), who show that changes in investors' subjective expectations of future dividend growth explain the majority of stock market movements. In this way, our model simultaneously accounts for the empirical findings of Greenwood and Shleifer (2014) on return expectations and the empirical findings of De la O and Myers (2021) on cash-flow expectations.…”

“…In our model, however, beliefs about returns and beliefs about dividend growth are closely tied to each other and both extrapolative; therefore, our model makes sense of both facts about return expectations (Greenwood and Shleifer, 2014) and facts about cash-flow expectations (De la O and Myers, 2021;Nagel and Xu, 2021). More broadly, our model is related to asset pricing models under biased or nontraditional beliefs in the form of natural expectations (Fuster, Hebert, and Laibson, 2011), diagnostic expectations (Bordalo, Gennaioli, and Shleifer, 2018), memory retrieval Kahana, 2020, 2021), and investor overconfidence (Daniel, Hirshleifer, and Subrahmanyam, 1998;Daniel, Klos, and Rottke, 2021).…”

Five Facts About Beliefs and Portfolios

“…One immediate implication of Fact 4 is in the time-series dimension (see De la O and Myers, 2017). As the Campbell-Shiller decomposition shows, cash flow expectations and expected returns have opposite effects on current valuations.…”

Volatility, Valuation Ratios, and Bubbles: An Empirical Measure of Market Sentiment

“…The variables and are, respectively, the cross‐sectional average subjective expectations of stock market returns over one‐ and 10‐year horizons, as reported by survey respondents, and are the corresponding average subjective expected excess returns, and and are disagreement measures at the same horizons (that is, the cross‐sectional standard deviations of reported subjective expected returns). Figure IA.10 compares with a quarterly time series of average subjective expectations of dividend growth constructed by De la O and Myers (2021). The measures of mean subjective expected returns and of mean subjective expected dividend growth are positively correlated with , whereas the measures of mean subjective expected excess returns and of disagreement are negatively correlated with .…”