PRIOR UNCERTAINTY, ANALYST BIAS, AND SUBSEQUENT ABNORMAL RETURNS

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Abstract
In this paper we examine the relation between analysts' overoptimism and uncertainty as proxied by the standard deviation of earnings forecasts. We find a positive relation between overoptimism and uncertainty, but very little or no optimism when uncertainty is low. If the uncertainty surrounding a firm is high, analysts have fewer reputational concerns when they act on their inclinations to issue optimistic forecasts. Portfolio strategies based on these findings generate abnormal returns. The results suggest that greater prior uncertainty leads to higher analyst optimism, which in turn causes market overvaluation and profitable portfolio strategies.