Belief overreaction and stock market behavior

 

Markets forms beliefs as embedded in the long-term earnings of stocks, yet the markets will often overreact to those beliefs which drives stocks higher only to see them fall or under-perform in the future. Investors love good news, and they believe that this good news will continue. The extrapolation of long-term earnings will lead to stock prices to being pushed higher only to fall when the market finds that their optimism is not rewarded. This seems to be a very reasonable story that can be applied to all markets as presented in the simple paper, "Belief Overreaction and Stock Market Puzzles". 

This paper solves the stock market puzzle that there is excessive return predictability for both time series and with cross-sectional equity prices. Errors in expectations from relaxing the assumption of rational expectations leads a solution the stock market puzzle without generating complex models.

What this tells us is that if investors make mistakes, we can get variations in valuation that can be exploited. These can be exploited by the trends in prices. If expectational mistakes trend, then prices will trend. Instead of trying to focus where those expectations make mistakes it may be easier just to follow prices especially during periods of exuberance.