The booms and busts in U.S. stock prices over the post-war period can to a large extent
be explained by fluctuations in investors` subjective capital gains expectations. Survey
measures of these expectations display excessive optimism at market peaks and excessive
pessimism at market throughs. Formally incorporating subjective price beliefs into an
otherwise standard asset pricing model with utility maximizing investors, we show how
subjective belief dynamics can temporarily delink stock prices from their fundamental
value and give rise to asset price booms that ultimately result in a price bust. The model
successfully replicates (1) the volatility of stock prices and (2) the positive correlation
between the price dividend ratio and expected returns observed in survey data. We show
that models imposing objective or `rational` price expectations cannot simultaneously
account for both facts. Our findings imply that large parts of U.S. stock price fluctuations
are not due to standard fundamental forces, instead result from self-reinforcing belief
dynamics triggered by these fundamentals.
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