Are Markets Rational? Investors’ Response to Persistent Bias in Analysts’ Earnings Forecasts

This dissertation intends to address the following two issues: 1) Persistence of the bias in analysts' earnings forecasts; 2) Investors’ response to such bias. It extends the understanding of information economics in earnings studies, and is expected to improve asset pricing models, suggest better model specifications for earnings studies, provide regulatory policy implications, and facilitate discussions on investor rationality.

Using two look-back portfolio formation methods that capture salient features of analysts' past forecasting behavior, I form quintile portfolios that describe the range of analysts' forecasting behavior. The optimistic portfolios refer to the portfolios containing firm-quarters whose contemporaneous forecast errors are likely to be negative, while the pessimistic portfolios refer to the portfolios containing firm-quarters whose contemporaneous forecast errors are likely to be positive. Evidence that the two formation methods have significant predictive power for the contemporaneous forecast errors is found and this suggests that there is persistent bias in analysts’ earnings forecasts.

Investors’ response to the persistent bias is characterized by two hypotheses. The naïve expectations hypothesis (NEH) predicts that investors naively follow analysts’ past forecasting behavior, while the rational expectations hypothesis (REH) predicts that investors fully adjust for analysts’ past forecasting behavior when investors form their own expectations about contemporaneous earnings.

Major findings are reported regarding behaviors of two market participants − financial analysts and investors − in forming their expectations in quarterly earnings. The first set of findings provides strong evidence of persistent bias in analysts' forecasts. The second set of findings suggests that investors’ reaction to analysts’ forecasting behavior is complex. The data does not strongly reject the NEH in favor of the REH. It is speculated that investors sometimes seem neither naïve nor rational. Rather, they seem to possess another type of quasi-rational behavior other than naïve. As a result, the simple framework (NEH versus REH) used in this dissertation has a limit. The examination of a full range of investor behavior is encouraged for future research.