Knowledge that Transforms

We show that investors extrapolate from recent stock returns of locally headquartered firms when forming beliefs about aggregate stock market outcomes. While it may be optimal to rely on local information, these effects are unrelated to how informative local returns are on predictions of aggregate outcomes. Evidence from a sample of retail investors suggests this belief extrapolation is driven by investors’ own holdings of local firms. Our findings suggest that beliefs about information contained in public signals vary systematically with geography, and are an important component of local biases in equity markets.

We decompose cross-sectional differences in the level of price-earnings ratios using professional forecasts. High price-earnings ratios are accounted for by both low expected returns and overly high expected earnings growth. The magnitudes and timing of the comovements between prices, earnings growth, and returns are consistent with gradual learning rather than expectations being highly sensitive to recent realizations. Earnings growth surprises do not translate 1-1 into one-period returns but instead are gradually reflected in returns over time. A structural risk-premium model incorporating constant-gain learning about mean earnings growth replicates our findings and generates realistic dispersion and persistence in price-earnings ratios.

We measure investors’ short- and long-term stock-return expectations using both options and survey data. These expectations at different horizons reveal what investors think their own short-term expectations will be in the future, or forward return expectations. Across data sources, investors’ forward return expectations are countercyclical, especially when measured as forward risk premiums. This countercyclical variation is, however, excessive, as changes in forward return expectations are too large relative to subsequent realized short-term expectations. The excess variation in forward return expectations can help account for a meaningful share of the stock-price declines during the global financial crisis and the COVID-19 crisis.

We propose and examine a novel mechanism whereby holdings of dollar assets by foreign institutions can have a large, unexpected impact on foreign Treasury yields in crisis periods. Non‐U.S. institutions hold substantial dollar assets and hedge dollar exposures by selling dollars forward. In crisis periods, the dollar appreciates against other currencies. To meet margin calls on foreign exchange (FX) hedging positions, traditionally passive institutions liquidate domestic safe assets to raise cash. We show that during the recent COVID crisis, U.K. institutions with substantial dollar holdings and FX hedging positions sold large amounts of gilts, contributing significantly to the observed gilt yield spike.

We consider an informed large shareholder who can choose between making a takeover bid herself and initiating a sale to another acquirer. Such takeover activism complements direct takeovers because the very choice mitigates the asymmetric information problem, thereby improving efficiency. As more investors enter the market for corporate control, takeover activism increasingly replaces direct takeovers as the prevailing mode of disciplinary control change, matching the evolution in practice. Our model shows how this evolution, characterized by a symbiotic relationship between investor activism and private equity, arises to overcome asymmetric information and collective action problems through intermediated transactions.