Sentimental Discount Rate Shocks

This paper argues that the price-dividend ratio variability is explained in a large proportion by shocks affecting the subjective distribution of capital gain expectations: sentimental discount rate shocks affecting average beliefs explain at least 30% and disagreement shocks up to 20% of the variability of stock prices. The results from an estimated FAVAR model including the distribution of survey expectations show that in contrast to discount rate shocks, sentiment shocks produce a hump-shape response in the P/D ratio and introduce additional persistence into the impulse-response functions. These shocks played an essential role during the 2002 dot-com bubble by driving the boom and subsequent bust in asset prices. These results bring additional empirical evidence in favor of asset pricing models with subjective beliefs that match the survey evidence on the dynamics of expectations.