In this paper we propose a theory of asset pricing that assumes fully heterogeneous agents whose expectations continually adapt to the market these expectations aggregatively create. We argue that under heterogeneity, expectations have a recursive character: agents have to form their expectations from their anticipations of other agents’ expectations, and this self-reference precludes expectations being formed by deductive means. So, in the absence of being able to deduce expectations, agents—no matter how rational—are forced to hypothesize them. Agents therefore continually form individual, hypothetical, expectational models or “theories of the market,” test these, and trade on the ones that predict best. From time to time they drop.
