1. Introduction

The stock market crash of 2008 and the subsequent financial crisis constitute a rare episode whose scope and implications fall outside the life experience of American households. Whether and how those events affect people’s expectations is an important question. To the extent that expectations guide investment behavior, substantial changes in expectations due to the financial crash can lead to substantial changes in investment. Besides average beliefs of “the representative household,” the crisis may have an impact on heterogeneity of such beliefs.

This study uses data from the 2008 wave of the Health and Retirement Study (HRS) to study the impact of the crisis on people’s expectations. We estimate the effect of the crash on the population average of expected returns, the population average of the uncertainty about returns (subjective standard deviation), and the cross-sectional heterogeneity in expected returns (an indicator of disagreement). We show estimates from simple reduced-form regressions on probability answers as well as from a more structural model that focuses on the parameters of interest and separates survey noise from relevant heterogeneity. The measurement strategy makes use of the fact that the respondents of HRS-2008 answered the survey during twelve months from February 2008 to February 2009, a time period that includes the time of the stock market crash in early October. We show that the date of interview is largely independent of the respondents’ past expectations about the stock market, so even if the date of interview is non-random, it is unlikely to bias our results.

Our analysis looks at changes in expectations during the HRS sampling period of February 2008 through February 2009. It may be useful to recall some of the important events during this period. The subprime mortgage crisis began well before 2008, but the Dow Jones peaked in October 2007 above 14,000. By early 2008, though, the Dow was down to 12,000, and the rest of the year was characterized by a general decline until the crash of October. March 2008 saw the failed bailout of Bear Sterns and its subsequent sale to JP Morgan, but the rest of the Spring and the Summer went relatively quietly. On September 15, Lehman Brother filed for bankruptcy. The financial system was thought to be in severe danger, and it took a few weeks of uncertainty and heated debates before the U.S. Congress passed the TARP bill on October 3rd. The Fall of 2008 also witnessed the run-up to the Presidential election on November 4th, which focused many people’s attention towards economic issues, but it also led to a natural uncertainty about future economic policy.

Figure 1 shows time series of four stock market variables over the course of the HRS sampling period. We divided the sampling period into four sub-periods on the figure: February to June, July to September, October to November, and December to February 2009. We shall use these sub-periods throughout our analysis; their definition was based on the stock market time series we discuss below.

The first panel shows the level of the Dow Jones Industrial Average and the VXD annualized volatility index1. After initial ups and downs, the level of the index started a substantial but gradual decline in June that stopped in August. The stock market crash hit in early October with a 3000-point drop in the Dow. The stock market experienced large swings in October and November, and the Dow reached a six-year low of 7500 in late November. After some recovery and a brief period of stability, the Dow experienced another period of steady decline in the first months of 2009. During the entire period, volatility showed the mirror image of the time series in levels, except that its increase started in September, and it reached its maximum in October and November. The second panel of Figure 1 shows the weekly volume of trade of the shares of the DJIA together with the trend of searches for the term ‘Dow’ on Google.2 The latter variable is an indicator for the attention people give to news about the stock market. The figure shows a strong co-movement of the two time series: increased attention to stock market news coincided with increased volumes in March and July of 2008, February of 2009, and, especially, October of 2008. The Google index is normalized so that its five-year average is one. The maximal 8.8 value in the first week of October means that almost nine times as many searches were made from the US for the Dow Jones Industrial Average than in normal times. Looking at the two panels together, we can see that the volume of trade was the highest at times when the stock market index was decreasing, when uncertainty was increasing and when people paid a lot of attention to news about the market.

The main question of this paper is whether and how expectations changed during the stock market crash in early October 2008 and the following months. We compare post-crash expectations to those earlier in 2008. It is important to keep in mind that the baseline period was characterized by early signs of the crisis and a depressed stock market. Nevertheless, the comparison can shed light on the effect of a large and perhaps qualitatively different event compared to the more “normal” declining market.

The crash may affect the population average of expected returns for various reasons. If people are unsure about the parameters of the returns process, they may use recent realizations to update their beliefs. In such a case, the crash would have a negative effect on everyone’s expectations. If, on the other hand, people believe in mean reversion in stock market prices, the effect may be of the opposite sign. Of course, people may not want to update their beliefs if they don’t learn from the returns. Besides stock prices, the political and policy news may have also affected people’s expectations about the future of the economy and the financial sector in general, and the stock market in particular.

Empirical papers about stock market expectations usually find that average expectations track recent changes in the level of the stock market. When the stock market is increasing, average beliefs become more optimistic and conversely. See, for example, Kezdi and Willis (2008) about American households and Hurd, Rooij and Winter (2009) about Dutch households. According to Kezdi and Willis (2008), it took a five hundred point gain in the Dow Jones to generate a one percentage point gain in expected yearly returns in 2002. With such a relationship, expected returns of respondents in November 2008 should be more than five percentage points lower than expected returns of respondents two or three months earlier. On the other hand, the financial crisis of 2008 may have affected people’s expectations in qualitatively different ways than the more gradual changes witnessed in 2002, especially if people had different views about the condition of the economy in 2002 and in 2008. People may expect asset prices to change in different ways after large sudden changes than gradual trends. This is the conclusion of Calvet et. al. (2009b) who, using Swedish data, found that people tend to invest in well-performing mutual funds but also tend to dispose of winning individual stocks at the same time.

The effect of the crisis on average uncertainty is more predictably positive. Stock market risk increased dramatically, as indicated by the trend in volatility on Figure 1. Even those who do not follow the stock market could become more uncertain about the future of the economy in general and the stock market, in particular, as general uncertainty has been “in the air” throughout the crisis.

The crisis may also affect the cross-sectional heterogeneity in households’ beliefs. Heterogeneity and potential subjectivity of people’s beliefs about future stock market returns has been the focus of recent developments in finance theory (see Hong and Stein, 2007 for an overview about disagreement models in finance). Harris and Raviv (1993) and Kandel and Pearson (1995) show that public announcements can increase disagreement about the fundamental value of assets if people interpret the news in different ways (see also Kondor, 2005). As Hong and Stein (2007) observe, this pattern is precisely the opposite of what one would expect based on a simple rational-expectations model with heterogeneous priors, where public information should have the effect of reducing disagreement, rather than increasing it. Similar mechanisms may increase disagreement after the stock market crash as well. Dominitz and Manski (forthcoming), for example, assume that the population is a mix of people who believe in the random walk hypothesis, who believe in the mean reversion of stock-prices and who believe in the persistence of trends on the financial markets. When the crash hit the economy and stock prices fell sharply, people holding these various views should have interpreted its implications in different ways, and consequently the disagreement among them should have increased. Indeed, a potential explanation of the trading pattern shown in Figure 1 is that the increase of disagreement created space for trade as more optimistic traders wanted to buy and more pessimistic traders wanted to sell. Note that potential heterogeneity in the effect of the crash implies that the average effect could go either way.

Our results imply a temporary increase in the population average of expectations right after the crash. At the same time, average uncertainty increased, perhaps as the result of increased stock market volatility. Our most robust finding is that cross-sectional heterogeneity in expected returns, an indicator of the amount of disagreement, increased substantially with the stock market crash. The effects are found to be largest among stockholders, those who follow the stock market and those with higher than average cognitive capacity. The result on average expectations thus masks a wide distribution of effects of opposing signs. We also document the co-movement of stock market expectations with ex-post returns, implied volatility and volume of trade.

Our finding suggests that there is heterogeneity in the cognitive processes (or mental models) people use to convert public news into personal probability beliefs, in accordance with some of the disagreement literature we mentioned above. The results on changes in heterogeneity complement recent empirical investigations that show substantial heterogeneity in stock market expectations of individual investors (Vissing-Jorgensen, 2003) as well as households (Calvet et al., 2007, 2009a and 2009b; Dominitz and Manski, 2007; Kezdi and Willis, 2008, Hurd, Rooij and Winter, 2009; Gouret and Hollard, forthcoming). This paper adds new results to this empirical literature by showing that the stock market crash and the financial crisis had significant effects on average expectations, average uncertainty, and perhaps most importantly, the heterogeneity of expectations.

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