Divergence of opinion and equity returns under different states of earnings expectations

In this paper, we show that divergence of opinion trades at a discount when analysts' earnings forecasts are optimistic and at a premium when analysts' earnings forecasts are pessimistic. Our results suggest that investors tend to exaggerate the quality of their foresight and invest in low dispersion stocks when earnings expectations are optimistic (i.e., sure winners) and avoid low dispersion stocks when earnings expectations are pessimistic (i.e., sure losers). In sharp contrast with Miller's (1977) view that high divergence of opinion leads to overvaluation, we find that overvaluation occurs when divergence of opinion is low and analysts' earnings predictions are optimistic. When analysts' forecasts are pessimistic low dispersion in analysts' forecasts reverses this valuation pattern.