Publications

Subjective Cash Flow and Discount Rate Expectations Journal of Finance June 2021 with Ricardo De la O (Download Expectations)

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.

Working Papers

Which Subjective Expectations Explain Asset Prices? with Ricardo De la O (July 2023)

Conditionally accepted at the Review of Financial Studies

Driehaus Center for Behavioral Finance Research Prize 

We present a method for determining whether errors in expectations explain asset pricing puzzles without imposing assumptions about the error mechanism. Using accounting identities and survey forecasts, we find that errors in expected long-term inflation explain price variation, return predictability, and the rejection of the expectations hypothesis for aggregate stock and bond markets. Errors in short-term (long-term) nominal earnings growth expectations explain (do not explain) stock price variation and return predictability. The relevant errors are consistent with mistakes about the persistence of forecasted variables and the response to surprises. A simple framework based on fundamental extrapolation successfully replicates these findings.

The Return of Return Dominance: Decomposing the Cross-Section of Prices with Ricardo De la O and Xiao Han (July 2023)

2023 Jacobs Levy Center Research Paper Prize for Best Paper; 2023 Marshall Blume Prize in Financial Research

What explains cross-sectional dispersion in stock valuation ratios? We find that 75% of cross-sectional dispersion in valuation ratios is reflected in differences in future returns, while only 25% is reflected in differences in future earnings growth. We show a similar dominance of predicted returns for explaining the dispersion in return surprises. The lack of earnings growth differences at long horizons provides new evidence in favor of long-run return predictability. We reconcile these conclusions with previous literature which has found a strong relation between prices and future profitability. Our results support models in which the cross-section of stock valuation ratios is driven mainly by discount rates or mispricing rather than future earnings growth. Evaluating five models of the value premium, we find that models based on risk premia struggle to match our results, whereas models based on mispricing perform better.

The  Cross-Section of Subjective Expectations: Understanding Prices and Anomalies with Ricardo De la O and Xiao Han (August 2023)

We propose a structural model of constant gain learning about future earnings growth that incorporates preferences for the timing of cash flows. As implied by the model, a cross-sectional decomposition using survey forecasts shows that high price-earnings ratios are accounted for by both low expected returns and overly high expected earnings growth. The model quantitatively matches a number of asset pricing moments, as learning about growth interacts strongly with the preference for the timing of cash flows, and provides insights on the roles of risk premia and mispricing in the cross-section of stocks. The magnitudes and timing of the comovement between prices, earnings growth surprises, and anomaly returns are all consistent with a gradual learning process rather than expectations being highly sensitive to the most recent realization. Large earnings growth surprises do not immediately translate into large one-period returns, but instead are gradually reflected in future returns over time. 

Public Employee Pensions and Municipal Insolvency (March 2022)

This paper studies how municipal governments jointly manage spending, credit market borrowing, and public employee pensions. I model governments as levered investors who must meet non-defaultable pension obligations and may value government spending more than citizens. I quantify the model using California city-level data, including a new record of fiscal emergencies, tax increases required to maintain essential services. After the financial crisis depleted pension funds, cities engaged in excessive risk-taking: the fiscal emergency option encouraged gambling for resurrection that kept cities vulnerable to shocks well into the recovery. Restricting risk-taking does not correct this problem, but a spending cap does.

Sovereign Debt, Government Spending Cycles, and Back-loaded Pension Reforms (November 2019)

This paper studies the effect of public pension obligations on a sovereign government's commitment to repaying debt. In the model, the government can renege on its pension promises but suffers a cost from losing the trust of households about future pensions. Large pension promises act as a commitment device for debt because they require the government to have regular access to credit markets. The government's decision to default is driven by its total obligations, not just its debt. Thus, there is a range of pension obligations large enough to act as a commitment device without raising total obligations to the point of default. This otherwise deterministic economy has an endogenous cycle in which periods of high spending and increasing debt are followed by periods of pension reform and debt reduction. The model successfully produces high debt in excess of 100% GDP without default and back-loaded pension cuts that match salient features of recent reforms in six EU nations.

Discussions

Hillenbrand and McCarthy "Heterogeneous Investors and Stock Market Fluctuations" (WFA June 2022)

Carlson, Giammarino, and Heinkel "Municipal Capital Structure" (ASU Winter Conference February 2022)