An updated paper by Adam, Beutel, and Marcet claims that booms and busts in U.S. stock prices can be explained by investors’ subjective capital gains expectations. Survey measures of these expectations display excessive optimism at market peaks and excessive pessimism at market troughs.

“Stock Price Booms and Expected Capital Gains”, Klaus Adam, Johannes Beutel, and Albert Macet.
Working paper, January 2014

The below are excerpts from the paper. Cursive lines and emphasis have been added.

The key evidence

“All quantitative survey measures of investors’…capital gains expectations available for the U.S. economy [from 1999 to 2012], unambiguously and unanimously correlate positively with the price-dividend ratio; and perhaps not surprisingly…expectations reached a temporary maximum…in the early part of the year 2000, i.e., precisely at the peak of the tech stock boom.”

N.B. This is based on the CFO survey, which is collected by Duke University and CFO magazine and collects responses from U.S. based CFOs. The Shiller survey data covers individual investors over the period and is released by Robert Shiller at Yale University. The UBS survey was the UBS Index of Investor Optimism.

The interpretation

“The positive co-movement of stock prices and survey expectations suggests that price fluctuations are amplified by overly optimistic beliefs at market peaks and by overly pessimistic beliefs at market troughs. Furthermore, it suggests that investors’ capital gains expectations are influenced…by the capital gains observed in the past, in line with evidence presented by Malmendier and Nagel (2011). Indeed, a simple adaptive updating equation captures the time series behavior of the survey data and its correlation with the price-dividend ratio very well.”

The rationalization

With imperfect information about the price process, optimal behavior dictates that agents use past capital gains observations to learn about the stochastic process governing the behavior of capital gains; this generates a feedback between capital gain expectations and realized capital gains.”

“We assume that investors are internally rational…This implies that all investors hold an internally consistent system of beliefs about variables that are exogenous to their decision problem and choose investment and consumption optimally. Although agents’ ’beliefs do not fully capture the actual behavior of prices in equilibrium, in line with the survey evidence, agents’ beliefs are broadly plausible given the behavior of equilibrium prices and the behavior of prices in the data.”

The explanation of booms and busts

“Formally incorporating subjective price beliefs into an otherwise standard asset pricing model…we show how subjective belief dynamics can temporarily de-link stock prices from their fundamental value and give rise to asset price booms that ultimately result in a price bust…

  • Stock prices in our model do increase with capital gain optimism whenever the substitution effect [desired increase of the equity share in the portfolio] of increased optimism dominates the wealth effect [re-allocation of equity valuation gains across the portfolio] of such belief changes. Asset prices in the model then display sustained price booms, similar to those observed in the data.
  • [When] increased optimism about capital gains has led to a stock price boom, stock prices make up for a larger share of agents’ total wealth…This eventually causes the wealth effect to become as strong as the substitution effect. Increases in optimism then cease to cause further increases in…stock prices, so that investors’ capital gains expectations turn out to be too optimistic relative to the realized outcomes. This induces downward revision in beliefs, which gives rise to negative price momentum and an asset price bust.”