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Fundamental factors and extrapolation in stock-market expectations: The central role of structural change

Roman Frydman and Joshua R. Stillwagon

Journal of Economic Behavior & Organization, 2018, vol. 148, issue C, 189-198

Abstract: Rational expectations and behavioral-finance models are widely interpreted as representing two distinct conceptions of decision-making: rational and irrational, respectively. Using survey data, this paper presents econometric evidence that both fundamental factors and extrapolation drive participants’ expectations of stock returns, but that they do so in ways that vary over time. Although both the REH and behavioral-finance approaches offer relevant insights for understanding participants’ expectations, neither of these distinct model classes is consistent with time-series data. The paper’s findings also suggest that structural change gives rise to ambiguity about the correct quantitative model driving outcomes. This ambiguity, faced by economists and market participants alike, is the key to according both fundamental and behavioral factors a role in rational forecasting.

Keywords: Automatic model selection; Asset-market expectations; REH; Behavioral finance; Structural change; Model ambiguity (search for similar items in EconPapers)
JEL-codes: D84 G41 C51 (search for similar items in EconPapers)
Date: 2018
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