Higher Order Expectations, Rational Confusion, and Short-term Trading

In a market with short term investors, when noise is persistent, a liquidity shock affecting the aggregate demand at a given period propagates to future periods’ aggregate demands. As a consequence, asset prices reflect investors’ higher order expectations about both the fundamentals and the noise stock, worsening the “rational confusion” problem investors face when extracting information from aggregate demands to forecast future prices. As a result, multiple equilibria with different levels of market depth and where the price can be a better or a worse predictor of fundamentals compared to consensus can arise. In this situation, a spike in fundamentals uncertainty acts as a coordination device and enforces a low depth equilibrium in which the price may either overor under-rely on public information. Conversely, a reduction in pay-off related uncertainty may lead to indeterminacy but potentially also yield higher levels of liquidity. Our analysis portrays a complex picture of Keynes’ Beauty Contest asset pricing allegory.