Analysts react to incentives, too

Regulators are necessary. There, I said it. There is always a balance to strike between too little regulation, which often comes at the expense of consumers, and too much regulation, which may come at the expense of an efficient market.

One of the areas that used to be a heavily unregulated market that was tilted against consumers was the market for sell-side research recommendations. Nobody checked if sell-side analysts gave fair ratings and recommendations on the stocks they covered. The result was that it all got out of hand during the tech craze of the late 1990s with sell-side analysts trying to attract issuers with favourable ratings to become clients of the investment banking arm of their employers. The result was that an analyst’s buy rating became effectively worthless as a signal to buy-side investors because the ratio of buy-rated stocks to sell-rated stocks was a whopping 39-to-1 (according to an analysis by Charles Kang and his colleagues).

After the tech bubble burst, regulators in the United States stepped in with Global Settlement regulations that require brokers to prominently disclose the ratio of buys to sells in their reports. The result was a decline in the buy-to-sell ratio to 6-to-1. This is desirable because it reduces the excesses of the 1990s and hopefully makes a buy rating more meaningful.

The problem just is that twenty years later, analysts have reacted to these incentives and now game the system the other way. Today, analysts are very much aware of the fact that their coverage and their rating distributions are being monitored by their employers and investors. 

So, what they tend to do is whenever they issue a buy recommendation on a stock, they try to find another stock on which to issue a sell recommendation in order to balance out their distribution of recommendations.

According to the study by Charles Kang mentioned above this trend towards issuing a sell recommendation in tandem with a buy recommendation is particularly strong for bulge bracket brokerage firms that are under more intense public scrutiny and for star analysts that are more prominent and face more intense public scrutiny. And stocks that are downgraded to “sell” in tandem with another stock being upgraded to “buy” are more often downgraded without a corresponding downgrade in earnings estimates. In essence, the analysts downgrade the stocks to sell because they have to in order not to skew their portfolios too much towards “buy” ratings.

20 years after the tech crash, we now have the unintended situation where sell ratings have become much less informative and in many cases meaningless because analysts just issue negative recommendations in order to manage their rating distribution. Analysts at smaller brokerage firms or companies that don’t have to adopt these US regulations now have an advantage because they can more clearly express their opinions. And when they issue a sell recommendation on a stock, investors should pay attention.