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Irrational Analysts' Expectations as a Cause of Excess Volatility in Stock Prices

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Author Info

  • Bulkley, George
  • Harris, Richard

Abstract

This paper investigates whether excess stock price volatility may be due in part to a failure of the market to form rational expectations. Using data on analysts' expectations of long run earnings growth for individual companies, we report a number of interelated results which lend support to this hypothesis. First we show that there is no statistically significant relationship between analysts' long run forecasts and subsequent earnings growth, suggesting that analysts' earnings expectations are excessively dispersed. Secondly, we provide evidence that analysts' expectations are reflected in market prices. These two results together imply that the cross-section of stock prices will also be excessively dispersed, so that stocks with low earnings expectations are underpriced and stocks with high earnings expectations are overpriced. As analysts' forecasts errors become apparent, stock prices should adjust accordingly and so excess returns should accrue. We demonstrate that analysts' forecasts are indeed negatively correlated with subsequent excess returns. All hypothesis testing uses panel regression techniques, and to circumvent the problem of cross-sectional dependence in the data we use a generalised method of moments estimator of the parameter covariance matrix.

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Bibliographic Info

Paper provided by Exeter University, Department of Economics in its series Discussion Papers with number 9608.

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Date of creation: 1996
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Handle: RePEc:exe:wpaper:9608

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Postal: Streatham Court, Rennes Drive, Exeter EX4 4PU
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Fax: (01392) 263242
Web page: http://business-school.exeter.ac.uk/about/departments/economics/
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Related research

Keywords: Volatility; Earnings expectations; Panel data;

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Cited by:
  1. Martin Wallmeier, 2005. "Analysts’ Earnings Forecasts for DAX100 Firms During the Stock Market Boom of the 1990s," Financial Markets and Portfolio Management, Springer, vol. 19(2), pages 131-151, August.
  2. Andreas Fuster & Benjamin Hebert & David Laibson, 2011. "Natural Expectations, Macroeconomic Dynamics, and Asset Pricing," NBER Working Papers 17301, National Bureau of Economic Research, Inc.
  3. Gordon Burt, 1997. "Cultural Convergence in Historical Cultural Space-Time," Journal of Cultural Economics, Springer, vol. 21(4), pages 291-305, December.
  4. George Buckley & Richard Holt, 2004. "Forecasting Cross-Section Stock Returns using Theoretical Prices Estimated from an Econometric Model," ESE Discussion Papers 47, Edinburgh School of Economics, University of Edinburgh.

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