Analyst Optimism and Incentives under Market Uncertainty

Published date01 August 2017
Date01 August 2017
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
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
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:
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.
C2017 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
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
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.

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