The Naive Extrapolation Hypothesis and the Rosy-Gloomy Forecasts

TL;DR

This paper examines how financial analysts' long-term forecasts are influenced by the Extrapolation Hypothesis, revealing biases towards growth and large firms, while also identifying macroeconomic factors affecting expectations.

Contribution

It provides empirical evidence supporting the Extrapolation Hypothesis and explores macro factors influencing analysts' long-term forecasts.

Findings

Forecasting errors are higher for growth and large firms.

Expectations tend to move together across different firm categories.

Macro factors beyond recent performance influence analyst forecasts.

Abstract

I study the behavior and the performance of the long-term forecasts issued by financial analysts with respect to the Extrapolation Hypothesis. That hypothesis states that investors, extrapolating from the firms' recent performances, are too optimistic about growth and large firms and too pessimistic about value and small firms. I find that the forecasting errors are higher for the growth firms and large firms, thus providing support for the Extrapolation Hypothesis. However, in addition to the rosy picture of the growth and large firms, the forecasts of the value and small firms are not so gloomy in many cases. My analysis also reveals that expectations move together for all categories of book-to-market and all sizes of firms. I proceed by investigating some common factors that may influence analysts' long-term forecasts, including co-movement and excessive optimism. I find that macro factors beyond a firm's recent performance may influence the formation of expectations.