Francesca Bastianello

Mental Models and Financial Forecasts
Date Posted:Mon, 16 Dec 2024 20:27:07 -0600
We uncover financial professionals? mental models?the narratives they use to explain their subjective beliefs. Using 82,000 equity reports, we prompt large language models (LLMs) to extract 3.5 million narratives, each combining a topic, sentiment, and time outlook. To ensure and validate the reliability of our output we introduce a multistep LLM-based approach as well as new diagnostic tools. We establish three sets of findings. First, narratives are centered around a limited set of topics, primarily focused on top-line items, with variation in topic focus over time and across industries. Narratives are mostly forward-looking, with three times as many arguments focusing on the future as on the past. Second, differences in sentiment, time outlook, and topic focus across forecasters strongly predict the level of disagreement in their subjective quantitative forecasts. Lastly, time-series variation in the average narrative?s sentiment and in the average narrative?s focus on top-line items closely track Shiller?s CAPE ratio (? = 0.84 and ? = 0.42), and the cross-sectional variation in narratives predicts key asset pricing patterns. Narratives associated with growth stocks are more optimistic and forward-looking than those for value stocks, consistent with forecasters (mis)perceiving growth stocks as having above-average growth potential. Overall, this paper helps bridge the gap between ?what forecasters believe? and ?why they believe it.?

Partial Equilibrium Thinking, Extrapolation, and Bubbles
Date Posted:Wed, 20 Dec 2023 15:43:25 -0600
We develop a dynamic theory of "Partial Equilibrium Thinking" (PET), which micro-founds time-varying price extrapolation. Extrapolative beliefs are present at all times, but only sometimes manifest themselves in explosive ways. Consistent with the Kindleberger (1978) narrative of bubbles, we distinguish between normal times shocks and "displacement shocks." In normal times, PET generates constant extrapolation and momentum. By contrast, following a displacement shock that increases uncertainty, PET leads to stronger and time-varying extrapolation, triggering bubbles and endogenous crashes. Our theory sheds light on both normal times market dynamics and the Kindleberger (1978) narrative of bubbles within a unified framework.

Expectations and Learning from Prices
Date Posted:Tue, 06 Apr 2021 14:11:50 -0500
We study mislearning from equilibrium prices, and contrast this with mislearning from exogenous fundamentals. We micro-found mislearning from prices with a psychologically founded theory of "Partial Equilibrium Thinking" (PET), where traders learn fundamental information from prices, but fail to realize others do so too. PET leads to over-reaction, and upward sloping demand curves, thus contributing to more inelastic markets. The degree of individual-level over-reaction, and the extent of inelasticity varies with the composition of traders, and with the informativeness of new information. More generally, unlike mislearning from fundamentals, mislearning from prices i) generates a two-way feedback between prices and beliefs that can provide an arbitrarily large amount of amplification, and ii) can rationalize both over-reaction and more inelastic markets. The two classes of biases are not mutually exclusive. Instead, they interact in very natural ways, and mislearning from prices can vastly amplify mislearning from fundamentals.