Evidence that Prices Do Not Fully Reflect the Implications of Current Earnings for Future Earnings: An Experimental Markets Approach

Posted: 30 Jan 1998

See all articles by Michael Calegari

Michael Calegari

Santa Clara University - Accounting

Neil L. Fargher

Australian National University (ANU)

Abstract

Analysts have been found to underweight the innovation in most recent quarter earnings when forecasting next quarter earnings, and these expectations have been posited as an explanation for post-earnings announcement drift. This study uses an experimental asset market to examine whether similar errors are made by student subjects in forecasting quarterly earnings. We examine two aspects of behavior: (1) Do subjects underestimate the autocorrelation in quarterly earnings when forming earnings expectations? and (2) Are asset prices consistent with subjects underestimating the autocorrelation in quarterly earnings? We observe errors in forecasts by subjects which underweight extreme innovations in the most recent quarter earnings by approximately forty percent. The prices in the experimental markets also fail to reflect fully the most recent innovation in quarterly earnings. We are able to predict the sign of the mispricing in 74 percent of the 135 markets from the mean initial earnings predictions of the subjects. These forecast errors observed in this study are consistent with forecast errors observed for analysts, and this consistency suggests that errors in analysts' forecasts may be at least partially attributable to the use of judgmental heuristics.

JEL Classification: M41, C91, G29

Suggested Citation

Calegari, Michael and Fargher, Neil L., Evidence that Prices Do Not Fully Reflect the Implications of Current Earnings for Future Earnings: An Experimental Markets Approach. Contemporary Accounting Research, Autumn 1997, Vol 14, No. 3, Available at SSRN: https://ssrn.com/abstract=2923

Michael Calegari (Contact Author)

Santa Clara University - Accounting ( email )

Santa Clara, CA 95053
United States

Neil L. Fargher

Australian National University (ANU) ( email )

Canberra, Australian Capital Territory 2601
Australia

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