Irrational Analysts' Expectations as a Cause of Excess Volatility in Stock Prices

Paper number: 96/08

Paper date: July 1995

Year: 1996

Paper Category: Discussion Paper


George Bulkley

University of Exeter

Richard Harris
University of Exeter


This paper investigates whether excess stock price volatility may be due in part to a failure of the market to form rational expectations. Using data on analysts' expectations of long run earnings growth for individual companies, we report a number of interelated results which lend support to this hypothesis. First we show that there is no statistically significant relationship between analysts' long run forecasts and subsequent earnings growth, suggesting that analysts' earnings expectations are excessively dispersed. Secondly, we provide evidence that analysts' expectations are reflected in market prices. These two results together imply that the cross-section of stock prices will also be excessively dispersed, so that stocks with low earnings expectations are underpriced and stocks with high earnings expectations are overpriced. As analysts' forecasts errors become apparent, stock prices should adjust accordingly and so excess returns should accrue. We demonstrate that analysts' forecasts are indeed negatively correlated with subsequent excess returns. All hypothesis testing uses panel regression techniques, and to circumvent the problem of cross-sectional dependence in the data we use a generalised method of moments estimator of the parameter covariance matrix.

JEL Classification Nos: C33, D84, G14
Keywords: Volatility, Earnings expectations, Panel data

Corresponding Author: Richard Harris, Department of Economics, University of Exeter, Amory Building, Rennes Drive, Exeter, EX4 4RJ,Great Britain, tel:(44) 1392 263215, fax: (44) 1392 263242, email: