Empirical studies have long held that investors should be wary of equity market predictions from Wall Street. For instance, Easterwood and Nutt (1999) concluded that analysts systematically underreact to negative information and overreact to positive information. Moreover, Chopra (1998) found average consensus 12-month ahead EPS growth forecasts to be more than twice the observed growth rates. Dreman and Berry (1995) too found that sell side forecasts differ significantly from actual reported earnings, and that only a minority of estimates fall within acceptable proximity of realized results. And Bradshaw, Brown & Huang (2012) uncovered only “weak evidence of persistent differential abilities by sell-side analysts to forecast target prices”.
Despite the compelling body of literature arguing that investors should take Wall Street prognostications with a grain of salt, we found inclination to examine this topic for ourselves after coming across a bulletin from a fairly prominent research and asset management shop today that indicated better than 12% upside potential for the S&P 500, based on a compilation of Wall Street price targets for each of the constituent companies in the index (we were surprised at the implication that the aggregated S&P price target contained valuable information).
The following chart summarizes our findings. The black series represents actual rolling 12-month (price-only) returns for the S&P 500, and the dashed gray series illustrates returns implied by the Bloomberg BEst Target Price. The graph covers a period from March 2004 to May 2016 (the entire history of the BEst Target Price data series at our disposal).
Most evident from the chart is the consistent over-optimism embedded in analyst expectations. Of the 135 pairs of rolling 12-month actual and forecast returns, estimates turned out to be too high 87 times (on more than 64% of all occasions). Further, over our examination period, the combined analyst perspective has NEVER called for a 12-month decline in the S&P 500 price level, despite negative 12-month price changes occurring almost once out of every four instances (on average). Analysts’ glass-half-full predilection might be explained by their tendency to downplay bad news and overemphasize good news, as documented by Easterwood and Nutt.
In addition to the excessive optimism we observed, we were also struck by the magnitude of analysts’ error. Over the period in question, the S&P 500 averaged rolling 12-month price gains of 6.7%, while the composite price target suggested an average 12-month returns of about 14.0%. Thus, the historical mean absolute deviation for analysts’ collective error is greater than 100% of their average forecast–consistent with the magnitude of overconfidence Chopra documented in his 1998 review.
Consensus price target-based forecasts have also tended to cluster rather tightly around the 14% average. While the standard deviation of actual 12-month returns has been 0.165, the standard deviation for the set of forecasts is roughly one-third that level–a most curious finding given that double-digit gains accrued in less than half of all occurrences.
Thus, our analysis of the the limited data at our disposal appears consistent with the existing literature on the subject. We documented only a weak (but statistically significant) correlation between 12-month S&P 500 (price-only) returns and returns predicted by the composite price target approach. Accordingly, we remain largely unswayed by Wall Street prognostications. Instead, we will continue to seek out and focus on factors demonstrated to matter to equity price movements over reasonable horizons.