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How does the market interpret analysts' long-term growth forecasts?

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  • Steven A. Sharpe

Abstract

This paper examines the effect of inflation on stock valuations and expected long-run returns. Ex ante estimates of expected long-run returns are constructed by incorporating analysts' earnings forecasts into a variant of the Campbell-Shiller dividend-price ratio model. The negative relation between equity valuations and expected inflation is found to be the result of two effects: a rise in expected inflation coincides with both (i) lower expected real earnings growth and (ii) higher required real returns. The earnings channel mostly reflects a negative relation between expected long-term earnings growth and expected inflation. The effect of expected inflation on required (long-run) real stock returns is also substantial. A one percentage point increase in expected inflation is estimated to raise required real stock returns about one percentage point, which on average would imply a 20 percent decline in stock prices. But the inflation factor in expected real stock returns is also in long-term Treasury yields; consequently, expected inflation has little effect on the long-run equity premium.

Suggested Citation

  • Steven A. Sharpe, 2002. "How does the market interpret analysts' long-term growth forecasts?," Finance and Economics Discussion Series 2002-7, Board of Governors of the Federal Reserve System (US).
    • Handle: RePEc:fip:fedgfe:2002-7
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    References listed on IDEAS

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    1. Robert S.Harris & Felicia C. Marston, 1992. "Estimating Shareholder Risk Premia Using Analysts' Growth Forecasts," Financial Management, Financial Management Association, vol. 21(2), Summer.
    2. Campbell, John Y & Shiller, Robert J, 1988. " Stock Prices, Earnings, and Expected Dividends," Journal of Finance, American Finance Association, vol. 43(3), pages 661-676, July.
    3. repec:wly:coacre:v:17:y:2000:i:1:p:1-32 is not listed on IDEAS
    4. William R. Nelson, 1999. "The aggregate change in shares and the level of stock prices," Finance and Economics Discussion Series 1999-08, Board of Governors of the Federal Reserve System (US).
    5. John Y. Campbell, Robert J. Shiller, 1988. "The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors," Review of Financial Studies, Society for Financial Studies, vol. 1(3), pages 195-228.
    6. Louis K. C. Chan & Jason Karceski & Josef Lakonishok, 2003. "The Level and Persistence of Growth Rates," Journal of Finance, American Finance Association, vol. 58(2), pages 643-684, April.
    7. Charles M. C. Lee & James Myers & Bhaskaran Swaminathan, 1999. "What is the Intrinsic Value of the Dow?," Journal of Finance, American Finance Association, vol. 54(5), pages 1693-1741, October.
    8. Rajan, Raghuram & Servaes, Henri, 1997. " Analyst Following of Initial Public Offerings," Journal of Finance, American Finance Association, vol. 52(2), pages 507-529, June.
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    Cited by:

    1. Julia Lynn Coronado & Steven A. Sharpe, 2003. "Did Pension Plan Accounting Contribute to a Stock Market Bubble?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(1), pages 323-371.
    2. Ulrike Malmendier & Devin Shanthikumar, 2014. "Do Security Analysts Speak in Two Tongues?," Review of Financial Studies, Society for Financial Studies, vol. 27(5), pages 1287-1322.

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    Keywords

    Forecasting ; Econometric models ; Stock - Prices;

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