Economic downturns brought about by events such as the financial crisis and COVID-19 pandemic create substantial uncertainty for companies. While some firms endure the downturns unscathed or even thrive, others see their businesses decline drastically and their bankruptcy risk increase. The heightened uncertainty makes it especially difficult for market participants, such as investors and analysts, who rely on personal experience and public information to assess how a particular firm will perform during a downturn. In contrast, managers – as insiders – are better able to assess their firm’s future performance because they receive timely information about the firm’s operations and are motivated to respond to the volatile conditions. In a new study, we examine whether investors and analysts recognize managers’ relative information advantage during downturns and perceive management earnings forecasts as more informative during these times.
We measure the extent to which investors view management earnings forecasts as informative by how much stock prices change in response to a given amount of news provided in the forecasts, which we capture as the difference between a management earnings forecast and the prevailing analyst consensus earnings estimate. Similarly, we measure the extent to which analysts view management forecasts as informative by how much analysts revise their forecasts in response to news in management forecasts. We conduct our analyses on over 60,000 management forecasts issued between 2002 and 2017 and use recession periods, defined by the National Bureau of Economic Research, to identify downturns. There was only one downturn during this period, the Great Recession, which occurred between December 2007 and June 2009.
We document four key pieces of evidence that are consistent with investors and analysts viewing management forecasts as more informative during downturns. First, compared with stock price reactions to a given amount of news in management forecasts during normal times, the sensitivity of stock price reactions to the same amount of news in management forecasts is more than 28 percent greater during the recession. These larger price reactions are driven mostly by management forecasts containing bad news (i.e., management earnings forecasts that are lower than the consensus analyst earnings estimate). This finding is consistent with investors viewing bad news as more credible.
Second, we examine whether investors view management forecasts as more informative than analyst forecasts during the recession. Like investors, analysts are, relative to managers, at an information disadvantage during downturns. However, an analyst’s job is to follow a handful of companies and make informed forecasts. Therefore, we might expect that investors also view analyst forecasts as more informative during downturns but possibly less so than management forecasts. Consistent with this prediction, and suggesting a hierarchy in the informativeness of different sources of information, we find that stock price reactions are over 34 percent greater to a given amount of news in management forecasts than to the same amount of news in analyst forecasts during the recession.
Third, we find that analysts also view management forecasts as more informative during downturns. Compared with how much analysts revise their forecasts in response to news in management forecasts during normal times, when presented with the same amount of news during the recession, analyst forecast revisions are about 8 percent greater. Like our stock price reaction results, management forecasts that fall below analysts’ estimates (i.e., bad news) drive these findings.
Finally, we conduct two tests to ensure that our interpretation of our results is correct. While all our results are consistent with market participants viewing management forecasts as more informative during downturns, some of the results are also consistent with ambiguity-averse individuals overreacting to bad news during periods of heightened uncertainty. Inconsistent with this alternative explanation, however, we find no evidence of stock price reversals in the weeks following the initial market reaction to bad news in management forecasts. In contrast, and supporting our interpretation that investors justifiably view management forecasts as more informative because managers can better infer how a downturn will shape future earnings, the relative accuracy of management forecasts increases by about 6.5 percent during the recession compared with normal times.
Overall, our study shows that macroeconomic conditions create time-series variation in the informativeness of different sources of information to outside market participants. Although downturns increase uncertainty and create an environment where it is difficult to forecast earnings, our evidence suggests that managers have an information advantage compared with outsiders due to their position within the firm and their ability to respond to the downturn. Our study thus deepens our understanding of the circumstances under which a manager’s information advantage generates an edge over market paricipants in estimating future performance.
This post comes to us from professors David A. Maslar and Matthew Serfling at the University of Tennessee, Knoxville, and Sarah Shaikh at the University of Washington. It is based on their recent article, “Economic Downturns and the Informativeness of Management Earnings Forecasts,” available here.