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Article Excerpt
Abstract We use the chain of events from the fall of the Berlin Wall to the reunification of Germany to examine how capital market participants respond to momentous and unprecedented events. Our examination measures the impact of these events on analysts' forecasts for the earnings of West German firms. Our results show a significant decrease in analysts' ability to accurately forecast earnings. Contrary to the public's euphoria, the sense of the market was generally negative about the implications of unification for West German firms. This negative sentiment was spread across most of the broad sectors, but within those sectors the results were significantly positive for select groups of industries. It appears that, in the face of this extraordinary event, financial analysts were detached from the emotions it engendered and were discriminating in their assessment of its impact.
Keywords: German reunification * financial analysts * forecast revisions * forecast errors * East Germany, West Germany, German economy, Berlin Wall * analysts' expectations * sectoral valuation * event studies * forecast earnings * valuation effects
JEL Classification G14 * P51
Introduction
On October 3, 1990, the two German people (62 million West Germans and 16 million East Germans) reunified as one nation. It was a moment of euphoria and hopeful expectations that would soon be tempered by the realities of the challenges facing the new national entity. It would be an understatement to assert that they were two very different parts. As one observer noted, "The west was one of the richest, most highly industrialized and technologically advanced nations in the world; the east was near bankrupt, economically and psychologically shattered after nearly 60 years under two successive totalitarian regimes." (Economist, September 30, 2000).
But after pouring $1.5 trillion into eastern Germany since 1990, many believe the effort to rehabilitate the east has been a costly failure. The east's position may further erode as European investment finds greater returns in other former Soviet Bloc countries such as Poland and the Czech Republic. Klaus von Dohnanyi, chairman of the commission that produced the government's blueprint for the east, recently warned that, "if we do not address eastern Germany, the financial burden on Germany will become unbearable in the next 15 years." (Landler, 2004)
This paper investigates the value reassessment of West German firms triggered by the chain of events culminating in the reunification of Germany. The fall of the Berlin Wall and subsequent events leading to reunification were monumental events in history, without precedence and beyond the experience of market participants. Their political and economic ramifications are still being played out today. So it is inherently interesting to examine how capital markets and market participants evaluated and reacted to this profoundly significant event. More fundamentally, this study addresses the question of whether the market can be trusted (i.e., are market expectations and prices rational) during a time of sweepingly monumental and unprecedented circumstances.
Our approach examines forecast errors and forecast revisions to financial analysts' forecasts for the earnings of West German firms around 10 important events leading to reunification. We also focus on the forecasts for selected sectors and industries within the German economy. These forecasts incorporate the consensus of financial professionals who closely monitor the financing, investing, and operating activities of a firm and its competitors within an industry and are in a superior position to generate predictions of future earnings. Earnings estimates are a regular feature of financial reporting in the popular press. A number of studies collectively demonstrate a strong relationship between share price and both forecast revisions and forecasts errors (Ball & Brown, 1968; Beaver, Clarke, & Wright, 1979; Brown, Griffin, Hagerman, & Zmijewski, 1987; Chopra, 1998; Fried & Givoly, 1982).
A couple of prior studies have examined stock price behavior associated with the fall of the Berlin Wall and found reunification event showing mixed results. Sultan (1995) uses the 30-stock DAX index, the Germany Fund, the S & P Index and Financial Times World Stock Index for world sample to examine the stock market reaction to German reunification. Sultan found higher daily price volatility for the DAX during reunification period (August 1989-July 1990). For example, the DAX rose sharply as reunification euphoria intensified but it fell in August 1990 and later. For the Germany Fund, Sultan observed similar trend in prices around the initial reunification period. That is, the Fund's premium increased to as high as 100 percent on January 26, 1990. Later, when the earlier forecasts for benefits and costs of this event were revised, the Fund's share price fell as much as 90 percent from its previous high. For the World Stock Index, Sultan found both positive and negative information effects based on the volatility of the stock returns. Schnusenberg (2000) finds significant negative abnormal returns for a sample of US multinational corporations and significant positive abnormal returns for German firms in the week following the fall of the Berlin Wall which he attributes to a potential for increased acquisition activity and expanded market share.
Examination of analysts' forecasts can provide a more direct assessment of the impact of an event on expectations for the future prospects of firms. Moreover, the informed judgments of financial analysts may be especially important inputs determining the capital markets' response to unprecedented events. As specialists steeped in the idiosyncrasies of individual industries and companies and their products, analysts can be particularly attuned to the nuance and possibilities created by an unprecedented event for the companies encompassed by their expertise. Financial analysts may also employ heuristic rules they find useful when confronted with situations of high complexity and uncertainty, whose solutions are intractable using standard economic models and techniques. Prior research accepts the notion that financial analysts' forecasts are reasonable surrogates for market expectations. For example, Givoly and Lakonishok (1979) find that financial analysts' forecasts of earnings per share have information content. Fried and Givoly (1982) extend their work further and provide evidence that financial analysts' forecasts provide a better proxy for market expectations than forecasts generated by time-series models. We assume that a rational capital market response to the events leading to German reunification will reflect the reasoned assessments of financial analysts.
We report a significant decrease in analysts' ability to accurately forecast earnings, which is consistent with the unprecedented nature of the events and a concomitant increase in risk. The results also show a significant downward revision in earnings forecasts for three events out of the ten information events identified in our paper. The three events are the fall of the Berlin Wall, the signing of the unification treaty, and the official unification of the two Germanys. For five events, the forecast revisions are negative but statistically insignificant. Only one event records a significant positive forecast revision. Taken collectively, these revisions suggest a negative sense of the market with respect to the...
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