Further evidence of the conflict in analysts recommendations is found when ratings of companies for which the analyst does underwriting and for companies for which they do not do the underwriting.  In 12 of 14 large firms, their recommendations on their own underwriting do worse than their recommendations on other companies in which they don’t do underwriting.   

Barber et al. found that after a string of years in which security analysts’ top stock picks significantly outperformed their pans, the year 2000 was a disaster. During that year the stocks least favorably recommended by analysts earned an annualized market-adjusted return of 48.66 percent while the stocks most highly recommended fell 31.20 percent, a return difference of almost 80 percentage points. This pattern prevailed during most months of 2000, regardless of whether the market was rising or falling, and was observed for both tech and non-tech stocks. While they didn’t conclude that the 2000 results are necessarily driven by an increased emphasis on investment banking by analysts, they do note that their findings should add to the debate over the usefulness of analysts’ stock recommendations to investors.

Even before the landmark decisions against investment banks for conflict of interest cost them over $1.5B there was Disclosure Regulation or Reg. FD.  This regulation mandates that when a company or company employee disseminates information, it must be disseminated to everyone with prejudice.  This means that they can no longer tell the inside scoop to analysts allowing them to have information before the general public.  This was viewed as unfair to the average investor and the increase in awareness by the general public created the political situation that demanded action.  This was championed by former SEC Chairman Arthur Levitt. 

But that was just the tip of the iceberg to investment banks that were making fortunes in fees from bringing  IPO’s and other offerings to market.  What was obvious to all when the market took the plunge at the turn of the century that analysts weren’t all doing independent analysis.

For example, many call analysts recommendations a “coded language” as buy doesn’t really mean buy and hold is almost certainly a synonym for sell.  The SEC reports  that one study showed that, in the year 2000, less than 1% of brokerage house analysts’ recommendations were “sell” or “strong sell” recommendations.  And of course, 2000 was a horrible year for stocks.

The evidence is overwhelming that there is, in fact, bias.  First Call has determined that the ratio of buy-to-sell recommendations by brokerage analysts rose from 6:1 in the early 1990s to 100:1 in 2000.  Numerous academic studies have shown that there is statistical bias, a lack of contrary evidence, and possibly most damming of all, common sense dictates that analysts would do what is their own, and their firms, best interest.

The Efficient Market Hypothesis evolved in the 1960s from the Ph.D. dissertation of Eugene Fama. Fama persuasively made the argument that in an active market that includes many well-informed and intelligent investors, securities will be appropriately priced and reflect all available information. If a market is efficient, no information or analysis can be expected to result in outperformance of an appropriate benchmark.

Faced with the inference that they cannot add value, many active managers argue that the markets are not efficient (otherwise their jobs can be viewed as nothing more than speculation). Similarly, the investment media is generally considered to be ambivalent toward the efficient market hypothesis because they make money supplying information to investors who believe that the information has value (beyond the time when it initially becomes public). If the information is rapidly reflected in prices, there is no reason for investors to seek (or purchase) information about securities and markets.

Although this is a much discussed subject, no discussion of financial markets can avoid this issue.