Analyst information and investor reaction, not a match made in heaven

Yesterday, I wrote about short-sellers and their excessively pessimistic target prices that are almost useless in figuring out what the share price will really do. But most analysts are traditional analysts working for brokerage firms and asset managers and they have long had a similar reputation of being overly optimistic. That is true, but not always. I have discussed research before that showed that while analysts are optimistic on average, pessimistic analysts are making better and more reliable forecasts. To be more precise, when people in general (and thus all investors) are in a more pessimistic mood, they tend to process information more slowly and become more deliberate in their actions. This reduces forecast errors of analysts.

The same result was found in a new study by researchers from the University of Augsburg in Germany. When market sentiment was low, analyst forecast errors were smaller. But the new study went further and looked at how investors react to analyst forecasts in times of optimistic and pessimistic sentiment.

Unfortunately, they found that in times of pessimistic sentiment, investors reacted less to analyst forecasts, even though that is when their forecasts were best. Meanwhile, in times of optimism and positive investor sentiment, analyst forecasts were not only less reliable, but also overly optimistic. Analyst forecast errors are biased towards setting price targets that are too high compared to what fundamental models would suggest. But unfortunately, in times of high investor optimism, share prices react more strongly to analyst forecasts.

This creates a potentially dangerous feedback loop. When analyst forecasts are most unreliable, investors follow analyst forecasts more closely and push share prices more aggressively to these less reliable analyst targets. And because analyst targets tend to be overly optimistic in times of high optimism, that means that in those periods of optimistic sentiment, analysts set targets that are too high, share prices react more strongly to these targets and markets move farther away from fundamental value.

But in periods of pessimistic sentiment, analyst forecasts are more accurate and would help push share prices more towards fair value. But in those times, the impact of analyst forecasts is diminished, and markets move more slowly towards fair value.

Analyst forecasts vary in accuracy and quality over the cycle, but it seems that investors pay attention to analysts at exactly the wrong time when analyst forecasts are most unreliable. They should pay more heed to analysts when optimism is in short supply.