Expectation Formation in Financial Markets: Heterogeneity and Sentiment

Abstract

We set up an endowment based asset pricing model in which agents have heterogeneous expectations about future price levels. Expectations are a function of fundamentals or trends, both interacted with sentiment. Agents are able to switch between expectation formation functions based on past performance combined with sentiment. Estimation results on the S&P500 index as well as its constituents reveal that there is heterogeneity between agents, with substantial switching between groups. We find that sentiment has both a direct and an indirect effect on expectations. Specifically, heterogeneity between groups is increasing in sentiment, and higher sentiment reduces the frequency of switching between functions. Our results imply that the true expectation formation process is a dynamic process based on multiple information sources.