Long-Term Expectations and Aggregate Fluctuations

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In line with Keynes’ intuition, stock market volatility and real economic activity are linked by expectations of long term profits. Using data on analysts’ expectations of earnings growth of S&P 500 firms, LTG, we show that current long term optimism is associated with a near term boom in major US financial markets, real investment, and other business cycle indicators. LTG optimism then jointly predicts disappointing earnings growth and a contraction in financial markets and real activity one to two years later. Overreaction of long term profit expectations emerges as a promising mechanism for reconciling Shiller’s excess volatility puzzle with the business cycle.