63 Pages Posted: 28 Dec 2017 Last revised: 24 Nov 2020
Date Written: November 23, 2020
There is a weak correlation between economic fundamentals and asset returns and disagreement about future asset prices is not spanned by disagreement about economic fundamentals. Both facts are inconsistent with leading asset pricing models. To address these puzzles, we develop an overlapping generations model with disagreement about the cross-sectional distribution of investors’ preferences and beliefs. This disagreement implies different beliefs about future asset demand even if economic fundamentals are known. Demand disagreement leads to a low correlation between asset returns and economic fundamentals (no “correlation puzzle“) and disagreement about returns that is not spanned by beliefs about economic fundamentals (no “disagreement correlation puzzle“). Demand disagreement explains important asset pricing facts such as excess stock market volatility, low means and volatilities of interest rates, valuation ratios predicting returns, Black’s leverage effect, and high trading volume unrelated to economic fundamentals, even in a setting with i.i.d. consumption growth and without hedging demands, recursive preferences, habit formation, or disaster risk.
Keywords: Disagreement correlation puzzle, correlation puzzle, demand shocks, demand disagreement, heterogeneous beliefs and time preferences, asset pricing puzzles, trading volume.
JEL Classification: D51, G10, G11, G12
Suggested Citation: Suggested Citation