Analysts’ Forecasts, Market Expectations, and the Misweighting of Firm-Level Information

• In Event: Market reaction to earnings
  In Paper Session: Market Reaction to Earnings

Abstract

Because investors’ expectations of future earnings are unobservable, a large body of literature uses the firm-specific consensus analyst forecast to proxy for the market’s expectations of future earnings. Numerous studies suggest, however, that market expectations differ from analysts’ forecasts. Using data from 1986 through 2012, we model the historical relation between security returns and firm-level variables, and we use this relation to obtain an alternative proxy for the market’s expectations of future earnings. We refer to this proxy as the ‘implied market forecast’ and document significant differences between the consensus analyst forecast and the implied market forecast with respect to their propensities to incorporate the information in our firm-level variables. We then show that both the consensus analyst forecast and the implied market forecast contain systematic errors. Based on the predictable errors in the implied market forecast, we create a trading strategy that generates significant excess returns which cannot be explained by the predictable errors in the consensus analyst forecast. In addition, our strategy, which uses the predictable errors in the implied market forecast, outperforms a strategy that uses the predictable errors in the consensus analyst forecast, especially in the more recent part of our sample period. Overall, our results reveal that the common practice of using analysts’ forecasts to proxy for market expectations underestimates the importance of information in firm-level variables, underscoring the importance of finding alternative proxies for market expectations.

Authors

• Sami Keskek, University of Arkansas

• James N Myers, University of Arkansas

• Linda Ann Myers, University of Arkansas