Investors’ Misweighting of Firm-level Information and the Market’s Expectations of Earnings
54 Pages Posted: 16 Jul 2014 Last revised: 23 Jan 2019
Date Written: Jan 2019
Recent studies re-examine the ability of fundamental earnings forecasts to proxy for the market’s expectations of earnings because analyst forecasts are biased and are available for only a subset of firms. We find that as a proxy for market expectations, fundamental forecasts contain systematic measurement errors analogous to those in analysts’ biased forecasts. This occurs because when estimating future earnings, investors misweight the information in many firm-level variables but fundamental forecasts are formed using the historically efficient weights on firm-level variables. Thus, we develop an alternative ex ante proxy for the market’s expectations of future earnings (‘the implied market forecast’) using the historical (and inefficient) weights, as reflected in stock returns, that the market places on firm-level variables. A trading strategy based on the implied market forecast error, which is measured as the difference between the implied market forecast and the fundamental forecast, generates excess returns of about 8% per year. These returns cannot be explained by investors’ reliance on analysts’ biased forecasts. Overall, our results reveal that market expectations differ from both fundamental forecasts and analysts’ forecasts.
Keywords: Market expectations; Mispricing
JEL Classification: M4, M40, M41
Suggested Citation: Suggested Citation