Earnings Expectations and the Dispersion Anomaly

Abstract

We show that investors do not fully unravel sell-side analyst forecast pessimism, as measures of prior consensus and individual analyst forecast pessimism predict both the sign of earnings surprises and the stock returns around earnings announcements. Firms with a high probability of forecast pessimism experience significantly higher announcement returns than those with a low probability. Importantly, our findings are driven by pessimistic short-term forecasts as opposed to optimistic longer-term forecasts. We further find that this mispricing is related to the difficulty for investors of identifying differences in expected forecast pessimism. We demonstrate how our findings provide a new explanation for the puzzling phenomenon that the dispersion in analysts’ earnings forecasts, which is also correlated with the probability of forecast pessimism, is negatively associated with future returns. Overall, we conclude that market prices do not fully reflect the conditional probability that a firm meets or beats earnings expectations as a result of analysts’ pessimistically biased short-term forecasts.