Management Earnings Forecasts during Price Pressure: Evidence from Mutual Fund Trades

Abstract

Does a company’s stock mispricing influence its decision to issue an earnings forecast? Does executive compensation affect the nature of the forecast? How does the market react to these forecasts? I address these questions using cross-sectional and time-series variation in stock mispricing related to the liquidity-driven trades of mutual funds. I find that managers issue earnings forecasts more frequently when their company’s stock appears mispriced. In answering the second question, I uncover unintended consequences of executive compensation schemes, in that managers of mispriced firms strategically withhold information from investors to benefit from stock option exercises. I also show that in responding to forecasts of mispriced firms, investors act as if they are able to distinguish informative management earnings forecasts from uninformative ones. Finally, the difference-in-differences estimations lend credibility to the results by exploiting the exogenous fund outflows due to the 2003 mutual fund trading scandal. Collectively, my findings highlight the interplay between stock mispricing, managerial earnings forecast incentives, the company’s resulting disclosure policy, and the market reaction to it.