The Froth Is Back

Thom Lambert —  6 May 2006

Today’s WSJ reports that professional stock analysts employed by brokerage firms are up to their old sunny ways. These “sell-side� analysts came under fire in 2002 for rendering falsely optimistic trading recommendations. Congressional hearings revealed that during the late 1990s, analysts’ “buy� recommendations outnumbered “sell� recommendations by nearly 100 to one.

Well, according to today’s Journal, “The froth is back�:

After the brokerage scandals involving biased analyst recommendations in the 1990s, Wall Street was supposed to start warning more often about stocks that could fall, rather than just giving upbeat views. But Mike Mayo, who covers bank and brokerage stocks at Prudential Financial Inc.’s Prudential Equity Group, thinks the research reforms of 2003 haven’t fundamentally changed Wall Street’s bullish bias.

In an article prepared for the May-June issue of CFA magazine, Mr. Mayo notes that Wall Street analysts have 193 “buy� recommendations on the 10 U.S. stocks with the largest market values. And how many sells? Just six.

I suppose this 193-to-six ratio is a bit of an improvement. It’s also possible that analysts genuinely hold these bullish beliefs about the stocks at issue. But that does seem pretty improbable. More likely, analysts are once again responding to pressures from their firms’ much more lucrative investment banking operations, which don’t want pessimistic (realistic?) recommendations that might put off actual or potential clients. Prudential’s Mr. Mayo has an alternative theory. He says this “systematic bias� toward optimism is the result of “the threat from covered companies to punish analysts with negative opinions by shutting off their access to management.�

Regardless of the source of their optimism, sell-side analysts appear to be less inclined to report equity overvaluation than undervaluation. Same goes for the managers of mispriced firms, who will generally take price-correcting action when they believe their stock to be undervalued, but not when they perceive it to be overvalued.

These facts have implications for insider trading policy: They suggest that insider trading that tends to drive inflated stock prices downward toward actual value is more beneficial in terms of stock market efficiency than insider trading that tends to drive stock prices upward. For more on this, see my forthcoming law review article Overvalued Equity and the Case for an Asymmetric Insider Trading Regime. (Discussed here.)

Thom Lambert


I am a law professor at the University of Missouri Law School. I teach antitrust law, business organizations, and contracts. My scholarship focuses on regulatory theory, with a particular emphasis on antitrust.

2 responses to The Froth Is Back

    Thom Lambert 7 May 2006 at 8:15 am


    Thanks for the comment.

    I’m not actually “criticizing analysts for having ‘too many buys.'” All I’m saying is that analysts can’t be counted on to identify instances of overvaluation. First, they tend (as you say) to follow companies on which they can make buy recommendations. Such recommendations are more likely to generate trading activity than sell recommendations, for anyone can respond to a buy rec, not just current holders of the stock or people who are willing and able to short-sell it. Brokerage operations are therefore more likely to generate business from buy recs than sell recs.

    Second, analysts don’t want to offend actual or potential investment banking clients, so they’re very reluctant to report instances of overvaluation. Instead, they frequently respond to overvaluation by quietly dropping coverage.

    Both of these tendencies make perfect business sense from the standpoint of analysts’ employers, financial firms with brokerage and investment banking operations. The brokerage operations benefit from high trading volume; the investment banking side benefits from not offending actual or potential clients.

    You say that “analysts are paid to cover companies that clients want covered.” That may be true for “buy-side” analysts — those that work for institutional investors trying to decide what stocks to buy and hold. But, at least in theory, the “sell-side” analysts who work for the brokerage operations of investment banks (the analysts the WSJ was discussing) are paid to discover mispricing from which individual investors can benefit. They should, in theory, be looking for overvaluation as much as undervaluation. Yet, they very rarely report the latter.

    In any event, my main point was not that analysts are doing a bad job (sell-side analysts are likely benefiting the financial firms that pay their salaries). Instead, it’s that analysts (and managers) cannot be counted on to identify instances of overvaluation. That fact, then, suggests that insider trading that drives stock prices downward (e.g., insider selling on undisclosed bad news) may be more beneficial than that which drives stock prices upward (e.g., insider buying on undisclosed good news). That’s the central claim of my latest law review article, which calls for deregulation of “price-decreasing insider trading.”


    The buy-sell ratio is a total red herring that reflects a perfectly reasonable selection bias, not taint.

    Analysts are paid to cover the companies that clients want covered, which tend to be companies that have positive prospects, not those on the decline.

    Consider the S&P 500: most of those companies deserve buy or hold ratings, because those that would warrant a sell rating will likely not remain in the index for long. Stated differently, you can’t rate a company sell after it’s gone bankrupt.

    Criticizing analysts for having “too many buys” is akin to criticizing Starbucks for not selling cars.