Overreaction and bias in the stock market

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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 D1/(r -g)
• D1 next expected dividend
• r required return
• g expected dividend growth rate

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Where does "g" come from?

• Earnings1 Earnings0 (Ret)Earnings0(ROE)
• If the retention ratio (Ret) remains constant
  over time,
• Earnings1/Earnings0 Dividend1/Dividend0 1g
• 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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Case 1
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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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Case 2a
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Case 2b
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Case 2 Discussion

• If
• True growth horizon lt 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
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Case 3b
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Case 3 Discussion

• If True growth horizon Forecasted growth
  horizon, and True growth lt 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
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Case 4b
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Case 4 Discussion
If True growth horizon lt Forecasted growth
horizon, and True growth lt 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.
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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.