The Association between Trading Recommendations and Broker‐Analysts’ Earnings Forecasts

Abstract

This study examines analyst forecast errors within the context of stock recommendations. We predict positive forecast error (i.e., optimism) for buy recommendations and negative forecast error (i.e., pessimism) for sell recommendations. We offer two explanations for this prediction: (1) the unconscious tendency to process information in a manner that supports one’s goal, which we refer to as the “objectivity illusion” hypothesis, and (2) the economic incentive to boost trade, which we refer to as the “trade boosting” hypothesis. The pattern of analyst forecast bias we predict (i.e., optimism for buys and pessimism for sells) is opposite in direction to that predicted by the management relations hypothesis—a commonly cited hypothesis for analyst forecast bias. We find broker‐analyst earnings forecast errors are significantly optimistic for buy recommendations and significantly pessimistic for sell recommendations, consistent with the objectivity illusion and trade boosting hypotheses. Our study indicates that the pattern of results reported in prior research (i.e., increasingly optimistic earnings forecasts as the stock recommendation becomes less favorable) is likely driven by a correlated omitted variable, actual earnings. Results of an analysis to distinguish between trade boosting and objectivity illusion appear more consistent with the objectivity illusion.

The Effect of Perceived Uncertainty on Analysts’ Recommendations and Earnings Forecasts

“…We see the significant increase in R 2 for this model as earnings are now included as an independent variable. This is consistent with the prior research by Eames et al (2002) who find R 2 of 48% when both forecasts and recommendations are included in the same model. In summary, the results of the experiment reveal that relative optimism in forecasts is reduced when perceived uncertainty is high.…”

“…The results also suggest that higher relative optimism in analysts earning forecasts results in more positive analyst recommendations and that the perceived uncertainty and confidence in forecasts also result in more favorable analyst recommendations. These results support the theory of motivated reasoning put forth by the behavioral literature and consistent with Eames et al (2002) who find that analyst forecasts are significantly optimistic for buy recommendations and pessimistic for sell recommendations. Motivated reasoning suggests that people are more likely to arrive at conclusions they prefer which enhances the use of strategies that are considered most likely to yield the desired results (Kunda, 1990).…”

“…If this were the main incentive, we would expect to find more optimistically biased forecasts for buy than for hold recommendations and more pessimistically biased forecasts for sell than for hold recommendations. In contrast to the findings of Kim and Lustgarten (1998) and Francis and Philbrick (1993), Eames et al (2002) show that analyst earnings forecasts are optimistic for buy recommendations and pessimistic for sell recommendations. These results support both the trade-boosting hypothesis, that analysts intentionally bias their forecasts and recommendations to boost trade, as well as an objectivity illusion hypothesis, that analysts unintentionally bias their output of forecasts stock recommendations to achieve consistency.…”

“…Their results are opposite of the previous findings, where sell recommendations are related to more favorable earnings forecasts and buy recommendations are related to less favorable earnings forecasts (e.g., Francis & Philbrick, 1993;Kim & Lustgarten, 1998 The prior research on forecast uncertainty is limited because it does not directly provide evidence to support the management-relations hypothesis. In addition to the omission of earnings forecasts as found in Eames et al (2002), additional omitted variables could also be confounded with earnings predictability.…”

The Regulatory Effect on the Performance of Financial Analysts: Time Series from Two Different Legal Systems

“…Das et al [31] found evidence consistent with this argument, noting that forecast error and measures of predictability are negatively correlated. However, Eames, Glover and Kennedy [39] replicated Francis and Philbrick's [27] study and found that the relationship between recommendation optimism and forecast optimism was reversed when actual earnings were included in the equation. Lim [40] argues that analysts may trade off positive bias for improved forecast accuracy resulting from access to better information.…”