Robustness and Dynamic Sentiment

Errors in survey expectations display waves of pessimism and optimism. This paper develops a novel theoretical framework of time-varying beliefs capturing this fact. In the authors' model, dynamic beliefs arise endogenously due to agents’ attitude towards alternative models. Decision-maker’s distorted beliefs generate countercyclical risk aversion, procyclical portfolio weights, and countercyclical equilibrium asset returns. A calibrated version of the authors' model is shown to jointly match salient features in survey data and equity markets.