Stock Market Volatility and Learning

We show that consumption-based asset pricing models with time-separable preferences generate realistic amounts of stock price volatility if one allows for small deviations from rational expectations. Rational investors with subjective beliefs about price behavior optimally learn from past price observations. This imparts momentum and mean reversion into stock prices. The model quantitatively accounts for the volatility of returns, the volatility and persistence of the price-dividend ratio, and the predictability of long-horizon returns. It passes a formal statistical test for the overall fit of a set of moments provided one excludes the equity premium.
Klaus Adam acknowledges support from the European Research Council Starting Grant (Boom & Bust Cycles) No. 284262. Al- bert Marcet acknowledges support from the European Research Council Advanced Grant (APMPAL) No. 324048, AGAUR (Generalitat de Catalunya), Plan Nacional project ECO2008-04785/ECON (Ministry of Science and Education, Spain), CREI, Axa Research Fund, Programa de Excelencia del Banco de España, and the Wim Duisenberg Fellowship from the European Central Bank.