Uncertainty and The Rationality of Market Earnings Expectations

We thoroughly examine the relationship between uncertainty and the rationality of market earnings expectations, using multiple uncertainty measures and the return predictability of analysts’ conditional biases (EHB). Contrary to predictions of existing theories, we find a positive time-series relationship and a negative cross-sectional relationship. To explain these results, we propose a limited attention model where information processing costs increase with uncertainty. Our model offers distinct predictions for investors’ attention allocation and information acquisition compared to existing models. We find strong empirical support for our model’s predictions using direct measures of investor attention. Our model also reconciles seemingly contradictory existing findings.
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