Blog - Investing Notes

July 12, 2005 – Regulation FD is Working?

The Securities and Exchange Commission (SEC) adopted Regulation FD (Fair Disclosure) effective October 2000. "The regulation provides that when an issuer, or person acting on its behalf, discloses material nonpublic information to certain enumerated persons (in general, securities market professionals and holders of the issuer's securities who may well trade on the basis of the information), it must make public disclosure of that information." In their June 2005 paper entitled "Who is Afraid of Reg FD? The Behavior and Performance of Sell-Side Analysts Following the SEC’s Fair Disclosure Rules", Anup Agrawal, Sahiba Chadha and Mark Chen assess the impact of Regulation FD on the accuracy and dispersion of sell-side analyst earnings forecasts. By examining earnings forecasts from March 1995 to June 2004, they determine that:

• The accuracy of both individual analyst and consensus earnings forecasts has decreased since implementation of Regulation FD. The decrease in consensus earnings forecast accuracy is especially pronounced for small companies.
• The dispersions of individual analyst earnings forecasts for specific companies have increased since implementation of Regulation FD.
• Both effects are larger for longer-range than for shorter-range forecasts.
• Both effects have grown over time since implementation of Regulation FD, suggesting an increasing level of compliance at a lower average level of disclosure, thereby forcing individual analysts to develop forecasts independently.

In summary, research results indicate that Regulation FD has leveled the playing field for all investors, and reduced the accuracy of sell-side analyst earnings forecasts.

If the average level of disclosure has decreased, insider buying and selling activity may be relatively more telling now than before Regulation FD.

The aggregate S&P 500 consensus earnings forecast is an important input to our Real Earnings Yield Model and Reversion-to-Value Model, so this research suggests growing instability for the stock market forecasts generated by these and similar models. Should we expect wider swings for the stock market because individual estimates of discounted cash flows are more dispersed and consensus estimates of the flows less accurate? Where is this volatility? Perhaps investors are deferring buy and sell decisions closer to the release dates for actual earnings than before Regulation FD.

Perhaps also the accusations against, and prosecutions of, corporate executives and analysts for some of the excesses of the Internet bubble have produced an environment of systematically (and inaccurately) low earnings forecasts.