Investor Conservatism and the Long Term Price Response to Management Earnings Forecasts

This paper examines the long-term stock returns associated with disagreements between managers' forecasts and analyst consensus estimates on quarterly earnings, and presents evidence consistent with the notion that investor conservatism leads to a delayed stock price response to management forecasts. We find that the short-term market reaction to management forecasts is larger (smaller) when managers are conservative (optimistic), confirming prior research. Further, returns in the period subsequent to the management forecasts but before actual earnings announcement (post-guidance period) show a significant upward drift for both conservative and optimistic forecasts. The asymmetry in the initial market response and the subsequent upward drift in stock prices suggest investors' conservatism in responding to management forecasts. That is, investors initially over-react (under-react) to bad news (good news) and subsequently correct their initial reaction. This conservatism on the part of investors is further supported by the finding that the magnitude of upward price drift is negatively (positively) associated with the magnitude of managers' conservatism (optimism). Using an ex-post measure of credibility, i.e., credible if the firm later meets or beats a subsequent analyst forecast and untruthful (lemon) otherwise, we find that credible forecasts in the optimistic group are associated with a significantly higher positive drift in stock prices than lemon forecasts in the same group, but there is no such differential drift within conservative forecasts. Finally, we find that the market rewards (penalty) for meeting (missing) earnings benchmarks, measured as the abnormal returns at the time of actual earnings announcement, are attenuated by the drift in stock prices in the post-guidance period.