Diagnostic Expectations and Stock Returns

Citation:

Bordalo, Pedro, Nicola Gennaioli, Rafael LaPorta, and Andrei Shleifer. Forthcoming. “Diagnostic Expectations and Stock Returns.” Journal of Finance.

Abstract:

We revisit La Porta’s (1996) finding that returns on stocks with the most optimistic analyst long term earnings growth forecasts are substantially lower than those for stocks with the most pessimistic forecasts.  We document that this finding still holds, and present several further facts about the joint dynamics of fundamentals, expectations, and returns for these portfolios.  We explain these facts using a new model of belief formation based on a portable formalization of the representativeness heuristic. In this model, analysts forecast future fundamentals from the history of earnings growth, but they over-react to news by exaggerating the probability of states that have become objectively more likely. Intuitively, fast earnings growth predicts future Googles but not as many as analysts believe. We test predictions that distinguish this mechanism from both Bayesian learning and adaptive expectations, and find supportive evidence. A calibration of the model offers a satisfactory account of the key patterns in fundamentals, expectations, and returns.

Notes:

First Draft, November 2016, This Draft, September 2017

 

Last updated on 11/16/2018