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Overreaction and bias in the stock market

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Back to forecasting Current stock value = PV future dividends P = D 1 /(r -g) D 1 = next expected dividend r = required return g = expected dividend growth rate

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Where does "g" come from? Earnings 1 = Earnings 0 + (Ret)Earnings 0 (ROE) Ret If the retention ratio (Ret) remains constant over time, Earnings 1 /Earnings 0 = Dividend 1 /Dividend 0 = 1+g g = (Ret)(ROE) The growth in dividend depends on: the proportion of earnings reinvested back into the company ROE

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Forecasting in a We try to guestimate: earnings growth the length of the growth period

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Mean reversion The tendency of earnings to revert to an average trend over the long run.

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EXPERIMENT 1 (Dechow and Sloan) Future vs. past earnings growth First year: Rank NYSE stocks based on their P/E ratios. Form ten portfolios from the cheapest to the most expensive stocks. For each portfolio calculate the average growth in earnings for the last five years. Then calculate the growth in earnings for the following five years. Second year: Re-rank the stocks according to P/E ratios and redo the above calculations. Keep doing this for 23 years.

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The relationship between P/E ratios and past and future earnings growth.

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Discussion Firms that had earnings growing fast in the past (expensive stocks) will experience a relative slowdown in the future. Firms that had earnings growing slowly in the past (cheap stocks) will experience a relative acceleration in the future. Earnings appear to revert to the mean.

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From bias to surprise Overestimating the duration of the mean reversion and the true value of the average growth rate can cause the market to overreact. That is, some prices will be pushed too high, while others will drop too low.

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True earnings Case 1 today True horizon Forecasted earnings

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Case 1: Discussion If: True growth horizon = Forecasted growth horizon, and True growth = Forecasted growth No overreaction

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True earnings Case 2a today True horizon Forecasted earnings

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Case 2b today True horizon True earnings Forecasted earnings

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Case 2: Discussion If: True growth horizon < Forecasted growth horizon, and True growth = Forecasted growth The market would be surprised by: - the relative poor performance of growth stocks :( - the relative good performance of value stocks :) Both surprises would be of equal magnitude.

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Case 3a today True horizon Forecasted earnings True earnings

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Case 3b today True horizon True earnings Forecasted earnings

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Case 3: Discussion If True growth horizon = Forecasted growth horizon, and True growth < Forecasted growth The market would be surprised by the relative poor performance of all stocks. pleasant surprises caused by growth stocks would be larger in magnitude than the unpleasant surprises caused by value stocks.

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Case 4a today True horizon Forecasted earnings True earnings

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Case 4b today True horizon True earnings Forecasted earnings

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If True growth horizon < Forecasted growth horizon, and True growth < Forecasted growth The market would be unpleasantly surprised by the relative poor performance of growth stocks and the relative good performance of value stocks. Unpleasant surprises caused by growth stocks would be larger in magnitude than pleasant surprises caused by value stocks. Case 4: Discussion

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EXPERIMENT 2 (La Porta): Analysts' forecast revisions Year 1: - In April, rank NYSE stocks based on analysts' consensus about future growth - Build ten portfolios (from low growth to high growth) - The following April, compare the revised estimation with the original ones. Year 2: - Re-rank the stocks and redo the procedure. Keep doing this for several years.

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Discussion Investors appear to overestimate the growth rate and the growth horizon. It appears earnings grow at a lower rate and revert to the mean faster than forecasted.

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