Are financial analysts eager postmen of bubble psychology? Evidence in the United Kingdom

• Date: 01 January 2020
• Published date: 01 January 2020
• DOI: http://doi.org/10.1002/ijfe.1732
• Author: William P. Forbes,Chen Su,Cormac O'Keeffe,Áine Murphy

RESEARCH ARTICLE

Are financial analysts eager postmen of bubble psychology?

Evidence in the United Kingdom

William P. Forbes

1

| Áine Murphy

2

| Cormac O'Keeffe

2

| Chen Su

3

1

School of Business and Management,

Queen Mary University of London,

London, UK

2

School of Business, Waterford Institute of

Technology, Waterford, Ireland

3

Newcastle University Business School,

Newcastle University, Newcastle upon

Tyne, UK

Correspondence

Chen Su, Newcastle University Business

School, 5 Barrack Road, Newcastle upon

Tyne NE1 4SE, UK.

Email: chen.su@ncl.ac.uk

Funding information

Newcastle University Business School,

Grant/Award Numbers: 2015/16 and

2012/13

Abstract

This paper examines the investment value of financial analysts' advice (earn-

ings forecasts and stock recommendations) to shareholders around two recent

bubble periods in the United Kingdom: the dot‐com bubble period and the

credit bubble period. We find that analysts' advice is valuable at the firm level,

as reflected in their recommendations for high‐tech stocks before and after the

dot‐com bubble burst. However, at the aggregate level, in neither bubble period

do we uncover a stable relation between average stock returns and analysts'

advice. The key to the lack of predictive power of analysts' advice does not

seem to be their predictable nature, as the responsiveness of returns to such

news, predicted or not, varies widely around the bubble periods studied.

KEYWORDS

aggregate earnings, analysts' stock recommendations, bubble psychology, earnings forecasts,

earnings–returns relation, financial analysts

JEL CLASSIFICATION

G01; G12; G17; G24

1|INTRODUCTION

Financial analysts have been portrayed as eager post-

men of bubble psychology by perhaps the most success-

ful investor in history, Warren Buffett. In his annual

letter to shareholders of Berkshire Hathaway Inc. in

2001, Mr. Buffett wrote

1

,

By shamelessly merchandising birdless bushes,

promoters have in recent years moved billions

of dollars from the pockets of the public to

their own purses (and to those of their friends

and associates). The fact is that a bubble

market has allowed the creation of bubble

companies, entities designed more with an

eye to making money off investors rather

than for them. Too often, an IPO, not profits,

was the primary goal of a company's

promoters. At bottom, the ‘business model’for

these companies has been the old‐fashioned

chain letter, for which many fee‐hungry

investment bankers acted as eager postmen.

But a pin lies in wait for every bubble. And

when the two eventually meet, a new wave

of investors learns some very old lessons:

First, many in Wall Street––a community in

which quality control is not prized––will sell

investors anything they will buy. Second,

speculation is most dangerous when it

looks easiest.

Could financial analysts be part of this predation on

investors temporarily grasped by animal spirits, which

1

See the Chairman's Letter to the Shareholders of Berkshire Hathaway

Inc., 2001 (available at https://goo.gl/6zpKyr).

Received: 8 October 2016 Revised: 22 October 2018 Accepted: 21 March 2019

DOI: 10.1002/ijfe.1732

wileyonlinelibrary.com/journal/ijfe

IntJ Fin Econ.2020;25:120–137.

© 2019 John Wiley & Sons, Ltd.

120

drive them towards the precipice of the oncoming

crash? Prior studies have established two major proposi-

tions on the earnings–returns relation: (a) earnings

changes and analysts' recommendation revisions are

positively related to stock returns at the firm level (Ball

& Brown, 1968; Womack, 1996) and (b) stock prices

react negatively to earnings news at the aggregate level

(Kothari, Lewellen, & Warner, 2006). However, plenty

of debates still surround the differential impact of earn-

ings on stock returns at the aggregate and firm levels

(see related literature summarised in Section 2.1).

Shiller's (2000) cyclically adjusted price earnings ratio

has been shown to have strong predictive power for

stock returns in nearly one and a half centuries (Camp-

bell & Shiller, 1998; Siegel, 2016). Shivakumar (2010; p.

336) points out the “lack of understanding of earnings

information, and its relation to the macroeconomy and

aggregate stock markets.”A recent study of Anilowski,

Feng, and Skinner (2007) finds some modest evidence

for an effect of earnings guidance on market returns.

Shivakumar (2007; p. 72) argues that a natural exten-

sion of Anilowksi et al. is “to examine whether aggrega-

tion of analysts' forecasts provides timely information

about the macroeconomy,”as analysts' forecasts might

be the earliest earnings news available to the market.

Aggregating such earnings forecasts could potentially

provide even more timely information about the

macroeconomy than the aggregate management fore-

casts or guidance.

This study focuses on two sectors around two recent

periods that have large elements of bubble psychology:

(a) the technology, telecommunication, and

media (TTM) sector over the dot‐com bubble period

1995–2002 and (b) the banking, finance, and insurance

(BFI) sector over the credit bubble period 2005–2012,

to examine how analysts' advice, conveyed by

means of earnings forecasts and stock recommenda-

tions, predicts earnings and thus stock prices, at the

aggregate and firm levels. The stories of the dot‐com

boom and the sub‐prime mortgage bonanza market are

two of the greatest and ultimately most damaging

in recent history. The dot‐com boom was much

shorter and more intense in the United Kingdom, begin-

ning with the spin‐off of Freeserve from the retailer

Dixons in September 1998 (Cellan‐Jones, 2001),

although the banking crisis was triggered somewhat ear-

lier in the United Kingdom than in the United States by

the collapse of Northern Rock in September 2007.The

financial crisis periods are of interest because the pop-

ping of the bubble can trigger financial reform to ease

conflicts of interest and moral hazard, such as the

European Union Market Abuse Directive of 2003 and

the Vickers Report following the 2007/8 financial

crash,

2

although evidence to confirm such a remedial

effect is mixed at best (Espanbodi, Espanbodi, &

Espanbodi, 2015). If financial analysts can add value

in these tumultuous sectors when a bubble takes hold,

we may feel more confident in the overall role in

predicting the nation's corporate prospects. Groysberg,

Healy, and Maber (2011) show how closely analysts'

pay and status largely reflect recognition, particularly

among institutional investors, rather than forecast accu-

racy. The huge growth in the two sectors, both in vol-

ume of trades and market capitalization, suggests that

financial analysts have a strong incentive to follow and

promote the fortunes of these stocks in the expansion

phase of the bubbles we study.

Shiller (2000; p. 139) states that “much of human think-

ing that results in action is not quantitative, but takes the

form of storytelling and justification.”We study the invest-

ment value of analysts' advice at times and in industries

where investors need it most, when great fortunes are

made or lost often on the basis of gut instinct. In particu-

lar, using a uniquely insight database, Morningstar

Company Intelligence, we evaluate the investment perfor-

mance against the tradable Fama–French factors after

accounting for transaction costs. Confirming insights of

earlier research, we find that analysts' advice is valuable

in predicting the returns of individual stocks but not in

predicting the value of the sector overall. Nor does it

appear that the reason for this muted return predictability

at the aggregate level, as compared with the firm level, is

the ease of predicting future revisions in earnings forecasts

and stock recommendations. Thus, it appears that finan-

cial analysts serve investors poorly when they need help

most, a result not emphasised in prior research. Our

results appear robust to sensible controls for the riskiness

of returns and transaction costs.

The remainder of this paper is organised as follows.

The following section briefly reviews related literature

on the earnings–returns relation and the value of ana-

lysts' stock recommendations. Section 3 describes the data

and research methods employed. Section 4 presents

empirical results at the firm and aggregate levels, and

Section 5 discusses why earnings news does not aggre-

gate. The final section concludes.

2|RELATED LITERATURE

It is well known that financial analysts play an important

role in the capital markets by collecting and analysing

2

See relevant policies, information, and services provide by the Euro-

pean Commission (available at: https://goo.gl/tRFM9T) and The Inde-

pendent Commission on Banking: The Vickers Report (available at:

https://goo.gl/FYXftB).

FORBES ET AL.121