Forecasting Bias: From Weather to Wall Street

/Forecasting Bias: From Weather to Wall Street

Forecasting Bias: From Weather to Wall Street

By | 2017-08-18T17:04:49+00:00 August 7th, 2014|Behavioral Finance|1 Comment

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.

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.”

Why Managers Care about the Stock Price After an EPS Announcement

Managers care about what happens to the stock price in the short run.

Issuing New Equity

If the firm wants to issue equity, managers would prefer that the stock price be higher in order to reduce dilution effects to their equity. Also, due to insider trading restrictions, firms are generally prohibited from issuing equity until after an earnings announcement, when informational asymmetries are lowest.

Selling Personal Stock

Similarly, also based on insider trading rules, managers are prohibited from selling personal holdings in stock until after an earnings announcement.

Comp Based on Near-Term Stock Price

Management compensation is also heavily reliant on stock options, which are often granted based on stock performance.  Managers want the stock price to be higher so they can get more options!

Collectively, these incentives provide managers with ample motive for guiding down analyst forecasts prior to an earnings announcement.

Management Has Some Ability to Influence the Stock Price

Managers also have some tools available to manipulate the reaction of a stock price to earnings announcements — by influencing the forecast.

For instance, firms sometimes provide earnings guidance and pre-announce earnings. This can occur, for example, when earnings will be materially different from subsequent earnings announcements, or when there is an “expectations gap,” which is essentially a lot of uncertainty around earnings estimates. As with any forecaster, individuals within the analyst community get unhappy when they are wildly wrong, so they are receptive to hints from managers that point them in the “right” direction.

Soffer et al. noted in “Earnings Preannouncements” (a copy is here) that when managers have good news, they release about half of that news in the pre-announcement, saving the rest for later when actual earnings are announced. With bad news, however, they release all the bad news, pushing down analyst expectations to levels low enough that they can then be beaten when earnings are released.

There are also behavioral forces at work, since under prospect theory people are more averse to losses than they value gains of a similar magnitude. Skinner and Sloan in “Earnings Surprises, Growth Expectations, and Stock Returns or Don’t Let an Earnings Torpedo Sink Your Portfolio,” (a copy is here) found that negative earnings surprises influenced stocks more negatively than positive surprises influenced them positively. The effect was greater for high growth firms, suggesting these managers may be more incentivized to establish a beatable target.

Incentives + Ability to Influence = Pessimistic Analyst Forecasts?

The Richardson et al. paper concluded that:

Pre-announcement forecast pessimism is strongest in firms whose managers have the highest personal capital market incentives to avoid earnings disappointments…This evidence suggests that managers opportunistically guide analysts’ expectations around earnings announcements to facilitate favorable insider trades after earnings announcements.”

With weather forecasts or with analyst forecasts: pay attention to the incentives.

As Charlie Munger has stated,

…I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther.”

The Weather Channel seeks to protect its interests, and so exhibits a “wet bias,” managing weather expectations down, which enables positive weather surprises. Similarly, managers seek to protect their interests by enabling positive earnings surprises, which they accomplish by managing down expectations in the analyst community.

People don’t like surprises, especially on the downside. Clearly, incentives abound to avoid those nasty surprises!

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About the Author:

David Foulke
Mr. Foulke is currently an owner/manager at Tradingfront, Inc., a white-label robo advisor platform. Previously he was a Managing Member of Alpha Architect, a quantitative asset manager. Prior to joining Alpha Architect, he was a Senior Vice President at Pardee Resources Company, a manager of natural resource assets, including investments in mineral rights, timber and renewables. He has also worked in investment banking and capital markets roles within the financial services industry, including at Houlihan Lokey, GE Capital, and Burnham Financial. He also founded two technology companies:, an internet-based provider of automated translation services, and, an online wholesaler of stone and tile. Mr. Foulke received an M.B.A. from The Wharton School of the University of Pennsylvania, and an A.B. from Dartmouth College.
  • Michael Milburn

    Reminds me of something I noticed at a company I used to work for. It seemed like all the business levers were being aggressively pulled in a short-term and non-sustainable way – and this happened just prior to the CEO retiring. My presumption was maximization of an improperly constructed incentive plan, as the stock tended to peak when he retired, dropping over 50% in subsequent years. The fallout was left for the next CEO who would build things up following the similar pattern and max things out in an unsustainable way and the stock peaked again around his retirement and also dropped considerably in the years afterwards. The stock is just now getting about back to where it was 7 yrs ago. Time for another retirement? From inside the company you can kind of feel these things happening, but as an investor, I wonder.

    Here’s a study from the American Accounting Association on CEO retirement and stock performance (from google search)