Focus Areas:    Insider Trading | Securities Regulation

The Froth Is Back

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.)