How to Make Money in Markets: Understanding Expectation Errors
A new working paper from Gennaili, Ma, and the one-the-only Andrei Shleifer.
Using micro data from Duke University quarterly survey of Chief Financial Officers, we show that corporate investment plans as well as actual investment are well explained by CFOs’ expectations of earnings growth. The information in expectations data is not subsumed by traditional variables, such as Tobin’s Q or discount rates. We also show that errors in CFO expectations of earnings growth are predictable from past earnings and other data, pointing to extrapolative structure of expectations and suggesting that expectations may not be rational. This evidence, like earlier findings in finance, points to the usefulness of data on actual expectations for understanding economic behavior.
The authors find that “high past year profitability is correlated with over-optimism, while low past year profitability is correlated with over-pessimism.”
In other words, to win in a market, one must identify how the market forms expectations, identify how that expectation is systematically flawed, and then exploit it to your advantage.
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Definitions of common statistics used in our analysis are available here (towards the bottom)