Analyst Disagreement, Forecast Bias and Stock Returns

by Anna Scherbina

Executive Summary — It is well documented that financial analysts' opinions are reflected in stock prices. The problem: Analysts often operate under incentives that are inconsistent with telling the truth. Retail investors, who tend to be less sophisticated, may fail to make proper adjustments for the more nuanced of the resulting biases, some of which might be reflected in market prices. To study the scope of market efficiency, Scherbina studied analysts' incentives, resulting forecast biases, and their potential impact on market prices. Key concepts include:

  • When the level of analyst disagreement about future earnings is high, the average forecast tends to be overly optimistic.
  • The "marginal investor," on average, fails to interpret analysts' earnings forecasts with an eye to inherent biases.
  • Sophisticated investors have a beneficial effect on market efficiency.

Author Abstract

I present evidence of inefficient information processing in equity markets by documenting that biases in analysts' earnings forecasts are reflected in stock prices. In particular, I show that investors fail to fully account for optimistic bias associated with analyst disagreement. This bias arises for two reasons. First, analysts issue more optimistic forecasts when earnings are uncertain. Second, analysts with sufficiently low earnings expectations who choose to keep quiet introduce an optimistic bias in the mean reported forecast that is increasing in the underlying disagreement. Indicators of the missing negative opinions predict earnings surprises and stock returns. By selling stocks with high analyst disagreement institutions exert correcting pressure on prices.

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