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Analysts’ Forecast Bias and the Mispricing of High Credit Risk Stocks

This paper investigates whether financial analysts’ power to move prices arises from investors’ tendency to blindly follow analyst earnings estimates. Analyst forecasts are often overly optimistic. This optimism is predictable and may generate temporarily inflated stock prices. In addition, for high credit risk stocks, the quintile predicted to have the most optimistic forecasts outperforms the quintile with the least optimistic forecasts by about 19% per year. Certain types of firms attract significantly more analyst optimism than others—namely those with poor credit quality. For these firms, the price distortions caused by analyst optimism are so large and frequent that they account for the negative credit risk-return relation observed in the cross section of U.S. stocks. UCLA Anderson School of Management, email: mark.grinblatt@anderson.ucla.edu. Department of Finance, School of Business, George Washington University, email: jostova@gwu.edu. Department of Finance, School of Management, George Mason University, email: aphilipo@gmu.edu. Keen observers of the stock market recognize that analyst recommendations and forecasts move stock prices. What is unclear is whether such price movements arise because of the rational dissemination of the analyst’s superior information or because of “animal spirits”—the tendency of investors to slavishly follow experts’ opinions, irrespective of their merit. Distinguishing which of these two views of analyst opinions is correct advances our understanding of what determines stock prices. Researchers who subscribe to the view that markets are efficient believe that analysts move stock prices because market participants recognize that analysts have access to superior information or analysis, leading to a more accurate portrait of the fair pricing of a stock. The alternative view—that analysts’ power to move prices arises from the blind tendency to follow—represents a behavioral perspective. If markets are efficient, the price movements generated by the news in analyst recommendations and forecasts should be permanent. That is, subsequent price movements will be random. Moreover, to the extent that the analyst’s view is predictable, and therefore not news, it should not move stock prices. If, alternatively, the behavioral perspective is correct, then both predictable and unpredictable analyst opinions may change stock prices. However, we would know that these analyst-driven price movements emerged from animal spirits and not news if they are temporary—that is, they subsequently tend to reverse. When these temporary price movements stem from a predictable analyst opinion, which cannot be news, the behavioral perspective on markets becomes particularly salient. This paper finds strong evidence for the behavioral perspective: Firms with more optimistic consensus analyst forecasts subsequently earn lower risk-adjusted returns. The most likely explanation for this “analyst-bias anomaly” is that optimism temporarily inflates prices and inflated prices deflate as more accurate earnings and revenue information is disseminated to the market. This obvious behavioral explanation distinguishes the analyst-bias anomaly from other major anomalies, which do not as readily reveal their root causes. Supporting this behavioral view of the analyst-bias anomaly is that the lower returns of firms with up-