Blog - Investing Notes

July 26, 2005 – Building a Good News Inventory?

In his recent paper entitled "Information Uncertainty and Analyst Forecast Behavior", Frank Zhang explores the effects of an increase in information uncertainty (from either volatility of underlying fundamentals or poor information) on the behavior of sell-side stock analysts. He hypothesizes that if behavioral biases cause analysts to underreact to new information when revising their forecasts, they underreact even more as information uncertainty increases. Using dispersion in analysts' earnings forecasts as a proxy for information uncertainty over the period 1983-2001, he determines that:

• Upward (downward) forecast revisions predict positive (negative) forecast errors and subsequent additional revisions in the same direction, and forecast errors and subsequent revisions are more pronounced for firms with greater information uncertainty.
• Analysts tend to walk up (down) their estimates for good (bad) news firms as the forecast horizon shortens.
• The effect of information uncertainty on analyst behavior is much stronger following bad news than following good news. Information uncertainty may be greater when management is sitting on bad news, which they release reluctantly.

In summary, stock analysts exhibit predictable underreactions in revising earnings forecasts. The degree of underreaction increases with the earnings forecast dispersion.

This paper, in the context of post-Internet bubble legislation and regulation, suggests an environment that builds and maintains a "good news inventory." The Sarbanes-Oxley Act and associated enforcement focus encourage corporate (and analyst) conservatism in earnings outlooks. Conservatism makes positive earnings surprises more likely than before. Also, as discussed in our blog entry of 7/12/05, the Securities and Exchange Commission's Regulation FD (Fair Disclosure) has increased the dispersion of earnings forecasts, magnifying the degree of analyst underreaction to earnings surprises. As summarized in the following chart, these processes combine to feed an inventory of latent earnings news that is larger and more likely to be positive than in the past.

Perhaps there is a cycle of alternating good news and bad news inventories related to the the level of government focus on regulation and enforcement, stimulated by abuses and attenuated by lulls. The following graph, which overlays the staffing level of the Securities and Exchange Commission and the S&P 500 index since the beginning of 1990, is slightly suggestive.

Separately, the analyst underreaction behavior described above may help explain the success of momentum investing (see the discussion in our blog entry of 7/19/05).

See also our blog entries of:

7/17/05 on the implications of earnings forecast dispersion for the Zacks system; and,

5/4/05 regarding the overconfident behavior of financial experts.