Short‐Term Institutions, Analyst Recommendations, and Mispricing: The Role of Higher Order Beliefs

• Published date: 01 June 2021
• Author: MARTIJN CREMERS,ANKUR PAREEK,ZACHARIAS SAUTNER
• Date: 01 June 2021
• DOI: http://doi.org/10.1111/1475-679X.12352

DOI: 10.1111/1475-679X.12352

Journal of Accounting Research

Vol. 59 No. 3 June 2021

Printed in U.S.A.

Short-Term Institutions, Analyst

Recommendations, and Mispricing:

The Role of Higher Order Beliefs

MARTIJN CREMERS,∗ANKUR PAREEK,†

AND ZACHARIAS SAUTNER‡

Received 15 July 2019; accepted 6 January 2021

ABSTRACT

We document that stocks that have optimistic (pessimistic) consensus recom-

mendations and are currently held by many short-term institutions exhibit

large stock-return reversals: Their large past outperformance (underperfor-

mance) is followed by large negative (positive) future alphas. The predictable

return reversals originate from overreaction to past recommendation releases

and the correction of these overreactions around future releases. Results are

stronger when earnings news is released and at firms with higher fundamen-

tal uncertainty. Further, firms with more short-term institutions show stronger

announcement returns and price drift after recommendation changes. Our

∗University of Notre Dame; †University of Nevada, Las Vegas; ‡Frankfurt School of Finance

& Management

Accepted by Philip Berger. Weappreciate the ver y constructive comments from an anony-

mous referee. We also like to thank Lauren Cohen, Jesse Fried, William Goetzmann, Huseyin

Gulen (MFA discussant), David Hirshleifer, Harald Hau, Zhiguo He, Pedro Matos (EFA dis-

cussant), Florian Peters, Breno Schmidt (AFA discussant), David Sraer, Russ Wermers, and

Ramona Westermann, as well as participants at the American Finance Association (AFA)Meet-

ings, European Finance Association (EFA) Meetings, Midwestern Finance Association (MFA)

Meetings, Society of Financial Studies Finance Cavalcade, INQUIRE Europe Munich Confer-

ence, Geneva Summit on Sustainable Finance, the Roundtable on Long-Term Value in the

Corporation at Harvard Law School, and Georgia State University for their comments. An

online appendix to this paper can be downloaded at http://research.chicagobooth.edu/arc/

journal-of-accounting- research/online-supplements.

911

© 2021 The Authors. Journal of Accounting Research published by Wiley Periodicals LLC on behalf of The

Accounting Research Center at the University of Chicago Booth School of Business

This is an open access article under the terms of the CreativeCommonsAttribution License, which permits

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912 m. cremers, a. pareek, and z. sautner

results are consistent with models of higher order beliefs where short-term

institutions coordinate trading around public signals.

JEL codes: G12, G14, M40

Keywords: short-term institutions; analyst recommendations; mispricing;

higher order beliefs

1. Introduction

In standard asset-pricing models with a representative investor, higher or-

der beliefs—that is, investor beliefs about the beliefs of other investors—do

not matter, and stock prices reflect the discounted expected value of fu-

ture dividends. This is different from models that feature multiple investors

with heterogeneous information. In these models, the average expectation

of all investors determines stock prices, and investors’ beliefs about other

investors’ beliefs can cause a deviation between the prices and the funda-

mental values of stocks. The role of higher order beliefs in financial markets

can be traced back to Keynes’ [1936] comparison of the stock market to a

beauty contest, and interest in higher order beliefs models extends into the

present day.1

In higher order beliefs models, public signals play an important role in

the evolution of stock prices. Investors know that a public signal affects the

average belief about the next period’s stock price, as all investors observe

the public signal and combine it with their private information. Because

short-term investors are interested only in the next period’s stock price,

they rationally overweight the public signal compared to private signals.

This may lead to a short-term overreaction of the stock price to the pub-

lic signal, which is subsequently reversed when investors synchronize their

trading in the opposite direction to correct the mispricing (Abreu and

Brunnermeier [2003]). We refer to this mechanism as the “higher-order

beliefs hypothesis.”2

We test this hypothesis by examining whether short-term investors

overweight widely disseminated public signals about stocks, leading to

stock return predictability. For the public signals, we use analyst stock-

recommendation releases, which are visible and widely followed pub-

lic events that affect stock prices (Kacperczyk and Seru [2007]). At the

same time, there are several indications that analyst recommendations

1See Biais and Bossaerts [1998], Abreu and Brunnermeier [2003], Allen, Morris, and Shin

[2016], Bacchetta and van Wincoop [2008], Banerjee, Kaniel, and Kremer [2009], and Kon-

dor [2012].

2An anecdotal example of the role of higher order beliefs is the downgrade of Citigroup

by analyst Meredith Whitney in the financial crisis, which caused a large stock price drop.

In her downgrade, Whitney seemed to only reiterate information in reports by other analysts.

Because her downgrade was not based on new information, the reaction likely originated from

investors that thought Whitney would catalyze investor beliefs (see “When Meredith Whitney

Calls, Should You Listen?” The Wall Street Journal, April 9, 2009.)

short-term institutions, analysts, and mispricing 913

contain limited fundamental information. First, analysts are commonly

conflicted—they must generate trading volume and cater to management

(Irvine [2000], Ertimur, Muslu, and Zhang [2011]). This makes their rec-

ommendations less likely ex ante to convey fundamental information (Beyer

and Guttman [2011]). Second, Malmendier and Shantikumar [2014] show

that analysts frequently “speak in two tongues,” revising recommendations

in the opposite direction as their earnings forecast, which supports the

view that recommendations contain little fundamental information. Third,

there is little evidence that analyst recommendations predict stock prices

or fundamental values over the long term (Barber et al. [2001]).

Our proxy for the presence of short-term investors is fund turnover,

which is the average portfolio turnover of a firm’s institutional investors

(Gaspar, Massa, and Matos [2005]). For robustness, we consider owner-

ship by transient institutions (Bushee [1998], [2001]) and share turnover.

Our tests use U.S. stocks, but we confirm our main results for interna-

tional stocks. We demonstrate that short-term institutional ownership and

extreme analyst recommendations (“strong buys” and “sells”) are mean-

reverting over periods of one to two years but not in related ways, which

implies that both variables are strongly predictable.

We then document predictable return reversals for stocks with extreme

analyst recommendations and ownership by many short-term institutions

across the same one- to two-year period that both the presence of short-term

institutions and recommendations mean-revert. Using portfolio sorts, we

show that, for high fund-turnover stocks (top quintile), the value-weighted

long-short portfolio that sells (buys) stocks with the most optimistic (pes-

simistic) recommendations has an annualized five-factor alpha of 8.3% (t-

stat of 3.41). These future alphas reflect return reversals, as the stocks with

the most optimistic (pessimistic) current recommendations had positive

(negative) alphas in the past. In Fama-MacBeth regressions, we find that,

for high fund-turnover stocks, the next year’s average return is −4.7% when

analysts are optimistic and 4.5% when analysts are pessimistic.3

To show that our results are driven by analyst recommendations, we cal-

culate event-time cumulative abnormal returns (CARs) around recommen-

dation releases. The stocks that have the most optimistic (pessimistic) ana-

lysts and are held by many short-term institutions had much higher (lower)

CARs around previous recommendation releases. Large parts of these CARs

are reversed around future recommendation releases, when recommenda-

tions reverse back to the mean.

The return reversals support an interpretation in which analyst recom-

mendations act as coordinating signals for higher order belief traders, lead-

ing first to return overreactions and then to return reversals. However, the

return patterns may also be consistent with an alternative “information-

source hypothesis,” which holds that short-term institutions are more likely

3The return pattern for pessimistic analysts is weaker in portfolio sorts and in the interna-

tional sample.