Investor Sentiment and Analysts' Earnings Forecast Errors

We correlate analysts' forecast errors with temporal variation in investor sentiment. We find that when sentiment is high, analysts' forecasts of one-year-ahead earnings and long-term earnings growth are relatively more optimistic for “uncertain” or “difficult to value” firms. Adding these forecast errors to a regression of stock returns on sentiment absorbs a sizable fraction of the explanatory power of sentiment for the cross-section of future returns. This finding provides direct support the notion that investor sentiment affects the earnings expectations of hard to value firms. Additional tests suggest that this bias in expectations is unlikely to be strategic in nature. Our results provide new insight into the mechanism through which investor sentiment affects returns