Working Paper: NBER ID: w23863
Authors: Pedro Bordalo; Nicola Gennaioli; Rafael La Porta; Andrei Shleifer
Abstract: We revisit La Porta’s (1996) finding that returns on stocks with the most optimistic analyst long term earnings growth forecasts are substantially lower than those for stocks with the most pessimistic forecasts. We document that this finding still holds, and present several further facts about the joint dynamics of fundamentals, expectations, and returns for these portfolios. We explain these facts using a new model of belief formation based on a portable formalization of the representativeness heuristic. In this model, analysts forecast future fundamentals from the history of earnings growth, but they over-react to news by exaggerating the probability of states that have become objectively more likely. Intuitively, fast earnings growth predicts future Googles but not as many as analysts believe. We test predictions that distinguish this mechanism from both Bayesian learning and adaptive expectations, and find supportive evidence. A calibration of the model offers a satisfactory account of the key patterns in fundamentals, expectations, and returns.
Keywords: analyst expectations; stock returns; representativeness heuristic; long-term growth forecasts
JEL Codes: D03; D84; G02; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Model based on representativeness heuristic (D91) | Captures dynamics of expectations and returns (D84) |
| Overreaction to positive earnings news (G41) | Inflated expectations (D84) |
| Inflated expectations (D84) | Poor stock returns (G17) |
| Positive earnings growth (O44) | Overreaction by analysts (G41) |
| Analysts' optimistic forecasts (G17) | Poor stock returns (G17) |
| HLTG stocks (G19) | Poorer returns compared to LLTG stocks (G19) |
| Strong past earnings growth (O49) | Slowdowns in HLTG stocks (C41) |