Forecasting Bias: From Weather to Wall Street by David Foulke, Alpha Architect

Providers of forecasts often want to be right, but they also don’t enjoy surprising people on the downside. People don’t like nasty surprises.

Forecasting Bias

For instance, it is by now a well-known phenomenon that weather forecasters tend to predict rain more often than it tends to occur. In a famous study, it was shown that when the Weather Channel predicted a 20% chance of rain, it only ended up raining 5% of the time. This is known as “wet bias,” since the Weather Channel is systematically biased in favor of wet forecasts.

This makes sense, since in general the Weather Channel wants to improve its ratings and keep viewers, thereby protecting its interests; if the weather forecaster predicts sunny skies, and you plan a picnic but get rained out, you are going to be angry with the bad forecast. Maybe you won’t tune in to the Weather Channel next time. If they predict rain, and it winds up being sunny, however, well, no harm, no foul. As a rule then, weather forecasters prefer to manage our expectations down, but surprise to the upside.

The management of expectations with respect to forecasts also occurs in the stock market, where managers do the same thing as the weather forecasters, but do it with earnings forecasts.

In “The Walkdown to Beatable Analyst Forecasts: The Roles of Equity Issuance and Insider Trading Incentives,” (a copy can be found here) Richardson, Teoh, and Wysocki argue that managers play an “earnings guidance game,” whereby they selectively disclose information before an earnings announcement, thus “walking down” those estimates, so that the firm can then beat them. As a WSJ article put it,

If the game is played right, a company’s stock will rise sharply on the day it announces its earnings – and beats the analysts’ too conservative estimates.”

 

Full article via  Alpha Architect and more from the study below

The Roles of Equity Issuance and Insider Trading Incentives

Scott Richardson

University of Michigan Business School

701 Tappan St., Ann Arbor, MI 48109-1234

[email protected]

Siew Hong Teoh

Fisher College of Business, Ohio State University

2100 Neil Ave., Columbus, OH 43210

[email protected]

Peter Wysocki

MIT Sloan School of Management, E52-325

50 Memorial Drive, Cambridge, MA 02142-1347

[email protected]

Revised August 2001

Introduction

In this paper, we investigate allegations by security regulators and the business press that firms and analysts are involved in an “earnings-guidance game.” Critics have claimed that analysts make optimistic forecasts (above actual earnings) at the start of the year and then ‘walk down’ their estimates to a level the firm can beat by the end of the year. We develop and test hypotheses on this pattern of analyst optimism and pessimism based on firm and managerial trading incentives to avoid a “disappointment” on the official announcement of firm earnings.

The motivation for our investigation is straightforward. The recent business press is replete with articles alleging that firms deliberately attempt to deceive or pressure analysts into making ‘beatable’ or pessimistic forecasts (below actual earnings). Even as far back as 5/6/91, Laurie P. Cohen, staff reporter of the Wall Street Journal wrote in the article “Low-Balling: How Some Companies Send Stocks Aloft” that:

“… after securities analysts estimate what the companies they follow will earn, the game begins. Chief financial officers or investor-relations representatives traditionally give ‘guidance’ to analysts, hinting whether the analysts should raise or lower their earnings projections so the analysts won’t be embarrassed later.

And these And these days, many companies are encouraging analysts to deflate earnings projections to artificially low levels, analysts and money managers say. If the game is played right, a company’s stock will rise sharply on the day it announces itsearnings – and beats the analysts’ too conservative estimates.”