Analyst Optimism and Incentives under Market Uncertainty

• Published date: 01 August 2017
• Author: Jin Woo Chang,Hae Mi Choi
• Date: 01 August 2017
• DOI: http://doi.org/10.1111/fire.12138

The Financial Review 52 (2017) 307–345

Analyst Optimism and Incentives

under Market Uncertainty

Jin Woo Chang

University of Michigan

Hae Mi Choi∗

Loyola University Chicago

Abstract

We examine how analysts’ changing incentives driven by changes in market uncertainty

affect their forecast optimism. Analysts issue more optimistically biased earnings forecasts and

buy recommendations under high market uncertainty (VIX). The lower reputational costs and

larger benefits of optimistic output explain the increased optimistic output: Analysts are less

likely to be penalized for inaccuracy and can stimulate more trading activityfrom optimistically

biased output when market uncertainty is high. Wefind that the likelihood of analysts’ turnover

decreases, while the trading volume associated with optimistic output increases, with VIX.No

evidence suggests that analysts’ self-selection affects our findings on optimism and market

uncertainty.

Keywords: sell-side analysts, optimism, market uncertainty, reputation

JEL Classifications: G24, G29, G14, M40

∗Corresponding author: 16 E. Pearson St., Quinlan School of Business, Loyola University Chicago,

Chicago, IL 60611; Phone: (312) 915-6320; Fax: (312) 915-7032; E-mail: hchoi2@luc.edu.

We thank participants at the Financial Management Association (FMA) meetings (2013), participants

at the Midwest Management Association (MFA) meetings (2015), and numerous colleagues for their

helpful comments. We especially thank Jonathan Clarke for providing us with the All-star analyst data

and an anonymous referee, Swasti Gupta-Mukherjee, Kyle Handley,Bob Kolb, Srinivasan Krishnamurthy

(editor), Marco Navone, TomNohel, Jagadeesh Sivadasan, Steven Todd,and Qiaoqiao Zhu for their input.

All errors are our own.

C2017 The Eastern Finance Association 307

308 J. W.Chang and H. M. Choi/ The Financial Review52 (2017) 307–345

1. Introduction

Starting with Schipper (1991) and Brown (1993), and more recently Ramnath,

Rock and Shane (2008) and Bradshaw (2011), researchers have suggested that the

analyst-forecasting literature focus more on the context in which analysts make their

decisions. Schipper (1991) and Brown (1993) emphasize the roles of macroeconomic

factors in formulating stock price forecasts and recommendations. Ramnath, Rock and

Shane (2008) describe the analyst reporting environment, in which macroeconomic

conditions are an important factor in obtaining and analyzing information to produce

earnings forecasts and stock recommendations. Stock market volatility is viewed as

a market-based measure of economic uncertainty (Bloom, 2009).

Volatile market conditions not only increase firms’ earnings volatility, but also

increase the volatility of information signals about a firm’s value, since the firm is

not independent of the business conditions in which it operates. This increase in the

operational and information uncertainty affects all analysts in gathering information

about the effect of market-level factors on firm performance (Amiram, Landsman,

Owens and Stubben, 2014; Loh and Stulz, 2015). In this context, this study examines

whether the changes in market uncertainty affect sell-side analysts’ optimism when

they issue earnings forecasts and stock recommendations. Our goal is to shed new

light on information contained in analysts’ output and deepen our understanding of

the role of analysts’ incentives in their decision-making process.

Sell-side analysts face a tradeoff of incentivesbetween issuing accurate forecasts

to enhance their reputation and issuing optimistic forecasts to generate brokerage

trading activity (Hayes, 1998; Hong, Kubik and Solomon, 2000; Jackson, 2005;

Cowen, Groysberg and Healy, 2006; Beyer and Guttman, 2011) or to maintain a

favorable relationship with firm management (Francis and Philbrick, 1993; Chen and

Matsumoto, 2006; Mayew, 2008; Soltes, 2014; Brown, Call, Clement and Sharp,

2015). Maintaining forecast accuracy enhances the analysts’ reputation (Jackson,

2005), enables analysts to move to larger brokerage houses (Hong and Kubik, 2003),

and helps maintain job security (Hong, Kubik and Solomon, 2000). Despite the

reputational effects and career concerns associated with issuing optimistic forecasts,

however, there is vast evidence that analysts are on average optimistically biased

(Stickel, 1990; Abarbanell, 1991; Dreman and Berry, 1995; Chopra, 1998; Lim,

2001, among others).

Most of the studies mentioned above examine the cross-sectional relationship

between analysts’ incentives and optimistic output. In particular, the literature has

largely examined cross-sectional measures of uncertainty (e.g., analyst-forecast dis-

persion) in studying analyst optimism (Ackert and Athanassakos, 1997). We extend

the rich literature by taking a different approach and exploiting the time variation

in market-level uncertainty to study analyst incentives and output. The benefits of

using market-level uncertainty are twofold. The first is that it allows us to exploit

an exogenous variation in the analysts’ information environment that affects all an-

alysts, whereas cross-sectional firm-level uncertainty measures may be correlated

J. W.Chang and H. M. Choi/ The Financial Review52 (2017) 307–345 309

with analyst or firm characteristics. The second is that changes in market uncertainty

provide a framework in which we can analyze the costs and benefits of analysts’

optimistic output, by which we explain analysts’ incentives for optimistic output.

The scope of past empirical studies was largely limited to the benefits or the negative

consequences of optimistic output. We contribute to the literature by enlarging the

scope of our study to comprehensively investigating the effect of uncertainty on the

costs and benefits of analysts’ optimistic output, and the level of optimistic output,

all at the individual analyst level.

We set up a simple framework in which an analyst decides the optimal level of

optimistic output to maximize her utility, which is determined by her reputation level

and trading commissions. Building on prior cross-sectional studies, we expect that an

increase in optimistic output decreases the analyst’s reputation but increases trading-

commission benefits. When the level of uncertainty in the information environment

changes, the marginal costs and benefits of issuing optimistic output also change,

and therefore we expect the level of the analyst’s optimism to vary accordingly over

time.1

We use stock market uncertainty as a proxy for the aggregate fundamental

volatility of firms and, hence, the uncertainty of analysts’ information environment

in issuing earnings forecasts and stock recommendations. Market uncertainty is mea-

sured by the VIX index, which is the forward-looking 30-day implied volatility of

stock options. VIX is often used as a measure of stock market volatility or uncer-

tainty.2Bloom (2009) shows that stock market volatility (VIX) is strongly correlated

with firm and industry earnings growth dispersion, as well as gross domestic product

forecast dispersion. In a similar vein, Bekaert, Hoerova and Lo Duca (2013) find

that the fluctuations in VIX appear to heavily reflect movements in aggregate-level

uncertainty.

We first examine the changes in the marginal cost and benefit of analysts’

optimistic output to better understand the underlying changes in analysts’ incentives.

Wehypothesize that the reputational cost of optimistic output decreases with the level

of market uncertainty. When there is high uncertainty in the analysts’ information

environment, forecast inaccuracy can be attributed to noisy signals instead of the

analysts’ forecasting ability. To the extent that inaccurate forecasts lead to analysts’

reputational loss, we expect that analysts with poor performance due to optimistically

biased forecasts are more likely to be penalized by, for example, having to leave the

industry (Hong, Kubik and Solomon, 2000; Groysberg, Healy and Maber, 2011) or

move down to low-status brokerage firms (Hong and Kubik, 2003). Accordingly,

we examine how the relationship between prior optimism and the likelihood of

1Our marginal cost–benefit framework can easily be expanded to incorporate other costs and benefits of

optimistic output. We use trading commission as an example of a benefit of issuing optimistic output in

our main analysis, but we also examine other explanations such as maintaining a favorable relationship

with management in Section 5.

2See Bloom (2009), Bekaert, Hoerova and Lo Duca (2013), Nyborg and ¨

Ostberg (2014), Chung and

Chuwonganant (2014), among others.