This paper demonstrates that negative serial correlation in long horizon stock returns is consistent with an equilibrium model of asset pricing. When investors display only a moderate desire to smooth their consumption, commonly used measures of mean reversion in stock prices calculated from historical returns data nearly always lie within a 60 percent confidence interval of the median of the Monte Carlo distributions implied by our equilibrium model. From this evidence, we conclude that the degree of serial correlation in the data could plausibly have been generated by our model.

We study a Lucas asset-pricing model that is standard in all respects, except that the representative agent's subjective beliefs about endowment growth are distorted. Using constant relative risk-aversion (CRRA) utility, with a CRRA coefficient below 10; fluctuating beliefs that exhibit, on average, excessive pessimism over expansions; and excessive optimism over contractions (both ending more quickly than the data suggest), our model is able to match the first and second moments of the equity premium and risk-free rate, as well as the persistence and predictability of excess returns found in the data.