Diagnostic Expectations and Stock Returns

Pedro Bordalo, Nicola Gennaioli, Rafael La Porta, Andrei Shleifer

The Journal of Finance · 2019 · 384 citations · 42 references

Concepts

TL;DR

Analysts forecast fundamentals from observed earnings growth, but overreact to news by exaggerating the probability of states that have become more likely. We revisit La Porta's finding that stocks with the most optimistic analyst long‑term earnings growth forecasts have lower returns than those with the most pessimistic forecasts, and we document the joint dynamics of fundamentals, expectations, and returns of these portfolios. We explain the facts using a model of belief formation based on the representativeness heuristic. We find support for the model's predictions, and a quantitative estimation of the model accounts for the key patterns in the data.

Abstract

ABSTRACT We revisit La Porta's finding that returns on stocks with the most optimistic analyst long‐term earnings growth forecasts are lower than those on stocks with the most pessimistic forecasts. We document the joint dynamics of fundamentals, expectations, and returns of these portfolios, and explain the facts using a model of belief formation based on the representativeness heuristic. Analysts forecast fundamentals from observed earnings growth, but overreact to news by exaggerating the probability of states that have become more likely. We find support for the model's predictions. A quantitative estimation of the model accounts for the key patterns in the data.

References

42