Bias With Stock Recommendations Essay

Pages: 7 (1916 words)  ·  Bibliography Sources: 2  ·  File: .docx  ·  Level: Master's  ·  Topic: Communication - Journalism

Bias With Stock Recommendations

Following the Great Recession of 2008, the volatility of the stock market has become a topic of increasing interest due to its collective impact on the global economy. In this regard, in their study, "Analyst quality, optimistic bias, and reactions to major news," Cao and Kohlbeck (2011) sought to determine whether those characteristics that are congruent with superior analysts are also related to reductions in the asymmetric response to such stock recommendations. To this end, Cao and Kohlbeck (2011) revisited previous research in this area to identify analyst and brokerage-firm characteristics that are characteristic of superior ability of financial analysts to generate accurate stock recommendations. This paper reviews Cao and Kohlbeck's (2011) study concerning analyst quality, optimistic bias, and reactions to major news, followed by a critical analysis of the authors' conclusions. Finally, a summary of the research and salient findings are presented in the conclusion.

Review and Discussion

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Essay on Bias With Stock Recommendations Assignment

According to Cao and Kohlbeck (2011), studying the quality of the financial analyses provided by analysts is an important and timely enterprise today because such characteristics are closely associated with the asymmetric response of stock recommendations to public information shocks. Likewise, Mokoaleli-Mokoteli, Taffler and Agarwal (2009) report that, "Although research attests to the importance of financial analysts for the efficient functioning of the capital markets, in the recent past strong doubts have been expressed about the credibility and objectivity of their stock recommendations" (p. 385). Moreover, a number of issues have been advanced concerning sell-side analysts' recommendations that were almost Panglossian in their predictions, but which in reality did not appear to mirror their honest views concerning the reported stocks. Indeed, Mokoaleli-Mokoteli and his associates reports that, "By mid-2000, the percentage of buy recommendations had reached 74% of total recommendations outstanding while the percentage of sells had fallen to 2%" (Mokoaleli-Mokoteli et al., 2009, p. 385). Likewise, Cao and Kohlbeck (2011) also confirm that previous researchers have identified a degree of asymmetry between analysts' response concerning large positive vs. large negative information shocks. According to these researchers, "Analysts respond much more strongly to large negative price shocks and effectively do not respond to large positive price shocks" (p. 502). Previous research concerning the revisions of analysts' earnings forecasts provide support for analyst optimism as indicated by their propensity to underreact to previous bad news; the precise cause of the optimistic bias in analysts' reactions to major news, though, remains understudied (Cao & Kohlbeck, 2011). What is known, though, is that "Overoptimism is the tendency to overestimate the likelihood of desired outcomes and underestimate the frequency of unfavorable events and is one of the most cited biases in the literature on analysts' forecasts and recommendations" (Mokoaleli-Mokoteli et al., 2009, p. 386).

To help fill this gap in the body of knowledge concerning asymmetrical responses, Cao and Kohlbeck (2011) investigated whether financial analysts' characteristics are associated with their asymmetric response of stock recommendations between positive and negative information shocks. These researchers also speculate that those attributes that serve to differentiate superior analysts from their less adept counterparts are positively related to the timely promulgation of bad news concerning a company. Consequently, Cao and Kohlbeck (2011) predict that the asymmetric response will be less among superior analysts.

Based on their analysis of stock return/recommendation changes relationship, Cao and Kohlbeck confirmed that asymmetric reactions were less pronounced for those analysts that possessed superior attributes. Furthermore, the reduction in asymmetric reactions were more accentuated for those analysts in the top decile but the reduction was only discernible when such analysts reported negative private information about a company (Cao & Kohlbeck, 2011). In this regard, based on the preparatory analyses, Cao and Kohlbeck speculated that the asymmetric response is less for superior analysts for two fundamental reasons:

1. Superior analysts have a reputation advantage to attract new banking clients. As a result, other analysts are more likely to avoid negative views to attract new business. A sufficiently large negative shock permits these other analysts to downgrade while still maintaining an optimistic bias.

2. Superior analysts have incentives to reveal their negative private information to the market. Compared to analysts identified as providing no upgrade, superior analysts can provide a relative upgrade but still be relatively less optimistic in reaction to a negative price shock.

Pursuant to the foregoing, Cao and Kohlbeck (2011) anticipated that they would find less asymmetry for analysts that demonstrated superior attributes. Based on a sample of large price changes, the results obtained by Cao and Kohlbeck (2011) provide support for previous research by identifying asymmetry in the analyst response to large positive and large negative information shocks. Perhaps even more significantly, Cao and Kohlbeck (2011) also found that the proxy for the quality of analyst recommendations was inversely related to the probability of recommendation downgrades after large negative price shocks, suggesting a reduction in asymmetry as analyst quality improves. Furthermore, Cao and Kohlbeck (2011) maintain that such asymmetrical reductions are fueled by analysts in the upper decile. In this regard, Cao and Kohlbeck report that, "Analysts in the upper decile of analyst quality do not appear to respond to either positive or negative news events, whereas the majority analysts in lower deciles of analyst quality exhibit varying degrees of asymmetric response" (2011, p. 504).

Subsequent analysis by Cao and Kohlbeck (2011) determined that the reductions that they identified in the asymmetry only existed in those situations where analysts have negative private information based on their own earnings forecasts; these researchers, though, did not identify any support for the proposition that such observed asymmetry is associated with any specific banking affiliation. The results of the study by Cao and Kohlbeck (2011) are highly congruent with previous research that found asymmetry was associated with a general information processing bias among those analysts who were designated as being of lesser quality. According to these researchers, "Importantly, such a bias affects superior analysts less due, at least in part, to their effectiveness in translating earnings forecasts into recommendations. These findings are consistent with the stream of research that differentiates stock picking ability between superior and inferior sell-side analysts" (Cao & Kohlbeck, 2011, p. 505).

The analysis of analyst characteristics therefore represents a valuable enterprise because the research to date indicates that although analysts play an important role in the dissemination of bad market information because corporate stakeholders have little incentive to promulgate such information (Cao & Kohlbeck, 2011). For instance, according to Cao and Kohlbeck, "Bad news creates uncertainty in firms' information environment and thus presents traders with an opportunity to gain from information acquisition that would mitigate the uncertainty. It seems that the arrival of bad news increases the market demand for analysts' services, providing analysts additional incentives to deliver high-quality research" (2011, p. 505)). The results of the analysis by Cao and Kohlbeck (2011) showed that superior analysts are less likely to postpone the release of bad news concerning companies that are most salient to those investors who concentrate on downside risk and based their trading on security analysts' stock recommendations.

In sum, Cao and Kohlbeck (2011) found that downgrades take place more frequently after the negative shocks that occur following the promulgation of negative news vs. positive shocks, a finding that is also congruent with the asymmetry in analysts' recommendation changes that have been found by previous researchers; the unwillingness or inability of sell-side analysts, though, to incorporate negative information in their recommendations is not uniform across the analyst community (Cao & Kohlbeck, 2011). In this regard, Cao and Kohlbeck (2011) determined that analysts' tendency to downgrade following negative shocks is inversely associated with individual analyst characteristics that are indicative of higher quality. Moreover, the increasing difference between superior and inferior analysts is primarily attributable to the analysts in the top decile of the analysts reviewed. In addition, Cao and Kohlbeck (2011) identified support for the mediating effect of analyst quality on excessive downgrades following negative returns which may be attributable to superior analysts' effectiveness in translating earnings forecasts into recommendations. Across a variety of tests, the results of the study by Cao and Kohlbeck (2011) consistently indicate that the asymmetric response is less marked for superior analysts after controlling for investment banking relationship and other items affecting analysts' response.

Critical Analysis

Taken together, the findings by Cao and Kohlbeck (2011) indicate that sell-side analysts play an important role in the streaming of company-specific information, and the contributions of outside analysts in communicating such information to the investing public was more likely to be higher in those cases where the information was negative (Cao & Kohnbeck, 2011). This type of role for analysts is likewise congruent with the research to date that shows: (a) there is a demand for analyst service because management has stronger incentives to highlight good news than bad news, and (b) there is a supply of analyst service indicated by increased analyst informativeness with increasing uncertainty in firms' information environment (Cao & Kohlbeck, 2011).

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How to Cite "Bias With Stock Recommendations" Essay in a Bibliography:

APA Style

Bias With Stock Recommendations.  (2011, November 3).  Retrieved April 2, 2020, from

MLA Format

"Bias With Stock Recommendations."  3 November 2011.  Web.  2 April 2020. <>.

Chicago Style

"Bias With Stock Recommendations."  November 3, 2011.  Accessed April 2, 2020.