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There is widespread evidence of excess return predictability in financial markets. For the foreign exchange market a number of studies have documented that the predictability of excess returns is closely related to the predictability of expectational errors of excess returns. In this paper we investigate the link between the predictability of excess returns and expectational errors in a much broader set of financial markets, using data on survey expectations of market participants in the stock market, the foreign exchange market, the bond market and money markets in various countries. The results are striking. First, in markets where there is significant excess return predictability, expectational errors of excess returns are predictable as well, with the same sign and often even with similar magnitude. This is the case for foreign exchange, stock and bond markets. Second, in the only market where excess returns are generally not predictable, the money market, expectational errors are not predictable either. These findings suggest that an explanation for the predictability of excess returns must be closely linked to an explanation for the predictability of expectational errors.

There is extensive evidence in financial markets that expected returns are time varying and that excess returns are predictable. This evidence has obvious implications for portfolio allocations. From a theoretical perspective, it is important to understand the source of this predictability. Predictable excess returns run against some classic hypotheses made in economics like the expectations theory of the term structure of interest rates or uncovered interest parity between investments in different currencies. For the foreign exchange market a number of studies have documented a close relationship between the predictability of excess returns and the predictability of expectational errors about excess returns, suggesting that deviations from strong rationality are behind the predictability of excess returns.1 Since excess return predictability is a broad asset pricing phenomenon, which applies to many different types of financial markets, a natural question is whether the findings for the foreign exchange market apply to other financial markets as well. In other words, is there more generally a close link in financial markets between the predictability of excess returns and the predictability of expectational errors of excess returns? In order to address this question, we use evidence from surveys of market participants in four different financial markets: foreign exchange, stock, bond and money markets. The results are striking. First, in markets where there is significant excess return predictability, expectational errors of excess returns are predictable as well, with the same sign and often even with similar magnitude. This is the case for foreign exchange, stock and bond markets. Second, in the only market where excess returns are generally not predictable, the money market, expectational errors are not predictable either. The obvious implication from these results is that an explanation for excess return predictability in financial markets is likely to be closely related to an explanation for the predictability of excess returns. One always needs to be suspicious of survey data because of potential measurement problems. This will be discussed in some detail in the paper. But the pervasiveness of the evidence across countries, time periods, financial markets and market participants makes it hard to attribute all of it to measurement error. The surveys we use all involve actual market participants, either a substantial number of big financial institutions or large numbers of wealthy individual investors. It is important to focus on actual market participants. This avoids well-known biases associated with expectations by financial analysts, especially in the stock market. Moreover, it is market participants who ultimately drive asset prices through their trades. The methodology is simple. Consider the log excess return qt+n of an investment over n periods, between t and t + n, in an asset such as a stock, a bond, or a foreign currency investment. The following regression measures excess return predictability: equation(1) qt+n=α+βxt+ut+n,qt+n=α+βxt+ut+n, Turn MathJax on where xt is a variable or a vector of variables observable at time t. As elsewhere in the literature, β is significant in most cases. In standard asset pricing models the expected excess return is a risk premium. Therefore, if there is strong rationality, predictability in Eq. (1) can only be explained by a correlation of xt with the risk premium. 2 But alternatively the predictability in Eq. (1) can be explained by deviations from strong rationality. To examine this, survey expectations on excess returns Etsqt+n are used to compute the expectational error qt+n − Etsqt+n. 3 Its predictability is measured with the following regression: equation(2) View the MathML sourceqt+n−Etsqt+n=γ+δxt+vt+n. Turn MathJax on Strong rationality implies that expectational errors are unpredictable by information at time t. But in most cases δ is significant. Moreover, δ tends to be significant precisely when β is significant and the elements of δ are of the same sign and of similar magnitude as the elements of β. While evidence of predictability of expectational errors violates strong rationality, one needs to be careful not to necessarily interpret this evidence as a violation of more meaningful definitions of rationality. Fama (1991) suggests that “a weaker and economically more sensible version of the efficient market hypothesis says that prices reflect information to the point where the marginal benefits of acting on information do not exceed the marginal cost”. Sims, 1998 and Sims, 2003 has formally argued that agents may rationally only process a limited amount of information because of capacity constraints on processing information. At the same time other explanations of predictability of expectational errors cannot be ruled out, for example based on psychological behavior (see Hirshleifer, 2001 for a survey). This paper mainly documents the relationship between the predictability of excess returns and expectational errors. We do not attempt to give a definite answer to what accounts for this relationship. It is possible that the relationship is causal from the predictability of expectational errors to the predictability of excess returns. Examples of models where this is the case are Gourinchas and Tornell (2004) for the foreign exchange market and Cecchetti et al. (2000) for the stock market. But it could also be that a third factor causes predictability of both excess returns and expectational errors. A discussion of these issues is taken up in Section 5. The remainder of the paper is organized as follows. After reviewing some related literature in Section 2 and 3 describes the survey data sets used for each financial market. An Appendix A provides more details on data sources. Section 4 shows the results on predictability of expectational errors and excess returns from the two regressions above. Section 5 discusses concerns about measurement error and possible explanations for the predictability of expectational errors and the link between predictable expectational errors and excess returns. Section 6 concludes. An unpublished Empirical Appendix, available on our websites, gives additional empirical results.

This paper has identified a strong parallel between two types of predictability in financial markets. It is well documented that excess returns are time varying and predictable. But the errors of market participants in forecasting those excess returns are predictable in a similar fashion. This applies to stock, bond and foreign exchange markets across the world. The main results regarding the predictability of expectational errors can be summarized as follows: (i) expectational errors in the foreign exchange market are predicted by the interest differential for 6 out of the 7 currency pairs considered for the 1986–2004 period; (ii) using the UBS/Gallup survey for stock market returns between 1998 and 2003, expectational errors are predicted by the dividend-yield ratio or by a combination of the dividend-yield and a short-term interest rate; (iii) using the ICF/Yale survey for expected stock price changes over the period 1985–2003, expectational errors for the Dow Jones are predicted by the dividend-yield, while expectational errors for the Nikkei are predicted by the short-term interest rate; (iv) expectational errors on 10-year bonds are predicted by a combination of yields in our 8 industrialized countries over the 1987–2004 period. There is also predictability by the term spread; (v) there is little predictability of expectation errors for shorter maturities. The tables in the Empirical Appendix show that most results are robust to varying the horizon of prediction. What is striking is that the predictability of expectational errors tends to coincide with excess return predictability in each of these markets. This suggests that understanding what determines expectational errors is crucial in explaining excess return predictability. A convincing explanation need not only link time-varying excess returns with expectational errors, but it must apply to all markets as well.