Rational Trend-Followers and Contrarians in Excessively Volatile, Correlated Markets

This paper studies an overlapping generations model with multiple securities and heterogeneously informed agents. There are two types of multiplicity of equilibria, one due to noisy rational expectations and the other resulting from self-fulfilling prophecies. Under general conditions, there exists an equilibrium in which stock returns are highly volatile and strongly correlated, even if all underlying shocks are small and independent. Other equilibria include a highly volatile, weakly correlated one. When prices are partially revealing, less informed agents rationally behave like trend-followers, while better informed agents follow contrarian strategies. Trade volume has a hump-shaped relation with information precision, and is positively correlated with absolute price changes. Accurate information generally weakens agents’ trend-following and contrarian behavior, while it strengthens the properties of a highly volatile, strongly correlated equilibrium. Unlike existing noisy rational expectations equilibrium models, a fully revealing equilibrium is well defined and provides a useful link to the traditional literature. JEL Classification: G12