Robert Frank
discusses an attention-grabbing question in his presentation of different
assignments he posts to the students. As one peruses the reports of various
stock recommendations by analysts, invariably they point out to a ‘Buy’
recommendation. Alternatively, sometimes they might recommend a ‘Hold’ position
but rarely do they suggest a ‘Sell’ recommendation. He seeks to identify the
reasons behind this behaviour. All stocks do not behave in the same manner
since they are linked to their firm performance which is uneven. Hence the
stock prices would move a different trajectory for each firm and thus to a
stock investor or somebody holding the stock in his or her portfolio, the
decision cannot be the same. A genuine analyst would go into the intricacies of
the fundamentals and technical of the stock and base his or recommendations on
these foundations. A uniform recommendation in most cases defies the natural
order. It suggests a signal of some sort of manipulation.
To an analyst,
there are multiple dilemmas. There are payoffs associated with his or her
individual analytical skills which will be catalysed by the authority of the
recommendations. The organization too would not like to lose its credibility by
frequently making wrong calls. Further there is a question of analyst
neutrality. The organization might not just be preparing the stock analyst
reports but also engaged in consulting assignments with various firms. The
market for stock market recommendations is monopolistically competitive. There are
numerous analysts pitching their recommendations with number of right calls
being the differentiator point. In a context wherein an organization is an
outlier in pitching a sell recommendation and the stock price instead moves up,
the organization loses it’s credibility. Furthermore, it might also anger the
company thus losing any prospective consulting assignments.
The firm therefore
decides to adopt the safer approach in this game which evolves into a repeated
prisoner’s dilemma. To an individual analyst
too, it is a question of her career path. A wrong call, sell recommendation going
wrong could destroy her career completely both within and outside the
organization. It is in the individual self-interest of both the analyst and the
organization they represent to avoid loss of credibility of wrong call plus a
loss of assignments or careers and play safe wherein the only loss will be of
wrong call. If most of them have made the wrong call, the prisoner’s dilemma
which is the resulted outcome, will ensure everybody is worse off. The relative
risk-return trade-offs and ensuing payoffs will make everyone worse off.
There is another
angle to the evaluation or belief in suggestions of the stock market analysts. The
stock market analyst sells a service to the prospective customers. Yet there is
an information asymmetry that exists between the two. The analyst knows
something more of the stock than the buyer of services, a prospective investor.
The investor looks towards the analyst for his or her decisions on what to buy
and what to sell. In such a scenario, the analyst is expected to be impartial
and true to their clients. Yet, the information asymmetry brings about new
dynamics. As the analyst pitches their recommendation, the prospective investor
looking towards these reports as tools for decision making are unaware of the
analyst motivations. The analyst might have some stake in the firm and hence
would love to see the price up and thus suggest the buy recommendation. The analyst
has some insider information and thus wants to exit but on a higher price. Herein
too in absence of any disclosure, the analyst might pitch in the recommendation
which favours the payoffs for him or her. Some other occasion, the analyst has
positive information about the firm and wants to buy the stock but at a lower
price. They may issue a sell recommendation that would cause the price to fall
and then pick up the stock at lower prices. The resolution of these problem
would mean disclosure of the analyst and their firms on their holdings and
their transactions post recommendations. This would give an insight on the
possible motives behind the analyst recommendation.
Assume the
analyst and the firm has no pecuniary interest in the firms they are preparing
the recommendations. Therein too, certain information asymmetry would emerge
and create some barriers. This boils down to the consequences the recommending firm
would face in case their calls go wrong. If the payoffs are not adverse then
they have little incentive to work on their models for greater accuracy. Even if
they do work on fine-tuning their models, they have little incentive to apply
to retail clients or basically use the models for the benefit for a few
clients, thus a price discrimination. Secondly, there is an element of moral
hazard. In case of no adverse events following a wrong call would free them
from any improvisation on accuracy or correctness of the calls. They are free
to give calls based on their whims as long as some 50-60% or some acceptable
correct call rate emerges. The prospect of adverse selection rests now on the
investors and not on those advisors. The advisors can always issue a statutory
disclosure of not being responsible for the accuracy of their forecasts. They
can build credibility through past forecasts but issue disclaimers on future
forecasts.
On the whole,
the business of stock market recommendations revolve around the utilization of
information asymmetry between the advisors and the clients to generate revenues
and profits for the firm. This leverage would obviously differ from high paid
clients and the clients that look for basic advice since their willingness and
ability to pay is limited. It further boils down the linkages between the
individual payoffs for an analyst and the organizational payoffs. If both are synchronized
then there would be consistency in the calls. If there is a divergence then
self-interest to collective interest paradigm doesn’t function. This applies
not just at the economy or the society but at the organizational level.
The bottom line
however remains for the recommending agency. The agency would do its work. It gives
its recommendation. But it comes with the statutory warning. Any losses or
adverse impact is not their responsibility. The investors have to take their
own adequate precautions before accepting or rejecting the recommendations.
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