Investor Sophistication and Market Earnings Expectations

Abstract

This paper investigates whether sophisticated investors rely more on analyst forecasts than on time-series model forecasts in forming expected earnings. Specifically, I investigate if earnings-announcement-related returns are more closely associated with analyst (SRW) forecasts for firms for which the marginal investor is more (less) likely to be sophisticated. My proxies for investor sophistication are institutional ownership, analyst following, and firm size (Atiase [1985], Hand [1990]). I predict that market participants place more weight on the analyst forecast for firms with high institutional ownership, firms with high analyst following, and large firms. For a sample of 89,246 firm-quarter observations over 1980-1995, I find that the weight placed on the analyst (SRW) forecast is increasing (decreasing) in institutional ownership, analyst following, and firm size. Forecast availability (as captured by publication in The Wall Street Journal) or forecast accuracy cannot account for these findings. Overall, my results suggest that market earnings expectations do not consistently resemble either analyst or SRW forecasts. Rather, the cross-sectional variation in the relative weights placed on these two forecasts is related to proxies for the sophistication of the marginal investor.