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Sticky expectations and predictable equity returns

New research documents that company earnings expectations of analysts have historically been sticky, plausibly reflecting that it takes time and effort to update forecasts. Such stickiness can explain two important anomalies of stock returns: price momentum and outperformance of high-profitability stocks. Indeed, these two anomalies have been correlated and stronger for stocks where analyst expectations have been stickier.

Bouchaudy, Jean-Philippe, Philipp Krüger, Augustin Landierx and David Thesmar (2016), “Sticky Expectations and Stock Market Anomalies”.

The post ties in with the subject of information efficiency as summarized here.

The below are excerpts from the paper. Headings and cursive text have been added.

The predictability of equity returns

“The existence of stock-return predictability is a central theme in the asset pricing literature: several stock-level characteristics beyond market betas significantly predict future stock-returns…Two of the most economically significant anomalies…[are] quality and momentum.”

On evidence of momentum equity markets view post here.

Quality anomaly…[means that] stocks with high profitability ratios tend to outperform on a risk-adjusted basis. Quality or profitability has recently emerged as one of the stock-return anomalies with the largest economic significance. The corresponding long-short arbitrage strategy features high Sharpe ratios, no crash risk and very high capacity due to the high persistence of the profitability signal.”

N.B.: Predictability here is diagnosed with hindsight, i.e. by making the choice of predictor after the data have been observed.

Explaining predictability with sticky expectations

The quality anomaly can be directly related to a simple model of sticky expectations, in which investors update their beliefs too slowly…systematically under-reacting to new information (e.g., the release of earnings)…We take our model of expectation dynamics from the macro literature on information rigidity…The intuition behind this model is that forecasters decide to update their expectations at discrete intervals, but fail to incorporate new and relevant information in the meanwhile.”

“Assuming expectations are sticky… then, at the steady state…

  • earnings surprises predict future returns (post earnings announcement drift)…
  • past profits predict future returns (profitability)…
  • increases in past profits predict future returns (earnings momentum)…
  • past returns predict future returns (price momentum).”

“Thus, the model provides a joint rationalization for quality and momentum, which are arguably the most significant anomalies documented in the literature.”

Empirical evidence for sticky expectations and their relevance

To construct our sample of analyst expectations, we obtain earnings forecasts from the I/B/E/S…We retain all forecasts that were issued 90 days after the previous earnings announcement date. We focus on analyst forecasts for the current fiscal year as well as earnings forecasts for one and two fiscal years ahead. We calculate the consensus forecast at a given horizon as the median analyst forecast of all analyst forecasts issued in the 90 days after the previous earnings announcement date. Next, we match actual reported EPS from the I/B/E/S unadjusted actuals file with the analyst forecasts we retain.  We keep only firms listed on NYSE, Amex, or Nasdaq…We observe at least two sets of one and two year-ahead earnings forecasts between 1986 and 2013… In order to test our hypotheses, we also construct a sample of monthly stock returns…between 1990 and 2013.”

“We find that the average forecaster reduces her distance to the rational forecast by about 15% per month, a level of stickiness consistent with evidence on macroeconomic forecasters… We…find that analysts covering a larger number of industries have more sticky expectations…Stickiness tends to decrease with the analyst’s years of experience following the firm.”

“Assuming expectations are sticky…forecast errors should be predicted by past revisions…[and] revisions are autocorrelated over time…We find that there is momentum in forecasts, and that the intensity of the momentum is directly related to the stickiness of expectations.”


“We…calculate several signals based on firm-level stock market and accounting variables, which have been identified in prior studies to be associated with anomalous stock returns…

  • The net cash-flow from the firm’s operating activities…one possible measure of a firm’s fundamental value…
  • Return on assets is income before extraordinary scaled by total assets…[a] measure of operating profitability…
  • Return on equity is calculated as net income scaled by common equity…
  • Gross profitability is calculated…as revenues minus costs of goods sold scaled by total assets…
  • Momentum is the cumulative firm-level return between 12- months and 2 months ago.”

The first four signals correspond to various ways of measuring a firm’s accounting profitability. We verify that the anomalies documented in the literature are indeed present in our…sample of monthly stock returns. ..All strategies [based on these signals] have highly significant alphas even without hedging. Cash-flow and gross profitability are the strategies generating the strongest abnormal returns.

“[The figure below]…shows a strongly monotonic relationship between forecast errors and cash-flows, suggesting that analysts, in forming their expectations, do not take into account all available information.”


“Several [other] predictions [arise]…directly from of our simple model. First, our model predicts that firms subject to more sticky EPS forecast updating or more persistent cash-flows should also be more prone to both the quality and momentum anomalies. Second, the model also predicts that the quality and momentum anomalies should be positively correlated…In the data, we find strong evidence to support these two hypotheses: the magnitudes of both anomalies are increasing in expectation stickiness and cash-flow persistence. The tests of ancillary predictions also suggest that quality, like momentum, are well explained by the sticky expectation hypothesis.”


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