Forecasting the Forecasters: A Closer Look at Analyst Optimism Bias in Earnings Forecasts

Abstract

The capital asset pricing model necessitates a security market line of positive slope, though this slope is often negative in practice – low beta stocks historically outperform high beta stocks. I posit that analysts exhibit greater optimism bias on the earnings forecasts of higher beta stocks. These stocks thus frequently experience negative earnings surprises, which contributes to lower returns. I find that the effect of beta on optimism bias can be explained away for low to normal beta stocks, but remains significant and robust for high beta stocks. I also demonstrate a simple trading strategy, informed by my findings, that predicts when earnings targets are too optimistic and shorts those stocks before they announce.