NBER Working Papers by Devin M. Shanthikumar

Why do security analysts issue overly positive recommendations? One explanation is that analysts pick their favorite stocks and are truly too optimistic. An alternative explanation is that analysts distort recommendations to maximize trade commissions and underwriting business, particularly if affiliated with an underwriter. We use a novel approach to assess the relative importance of both explanations, exploiting the concurrent issuance of recommendations and earnings forecasts. We first show that small traders follow recommendations but not forecast updates; large traders discount recommendations and follow forecasts. As a result, analysts with conflicting interests may distort recommendations upwards to trigger small-investor purchases and to please management, but may not distort forec...

Traditional economic analysis of markets with asymmetric information assumes that uninformed agents account for the incentives of informed agents to distort information. We analyze whether investors in the stock market internalize such incentives. Stock recommendations of security analysts are likely to be biased upwards, particularly if the issuing analyst is affiliated with the underwriter of the recommended stock. Using the NYSE Trades and Quotations database, we find that large (institutional) traders account for the upward bias and exert no abnormal trade reaction to buy recommendations, and significant selling pressure in response to hold recommendations. Small (individual) traders do not account for the upward shift and exert significantly positive pressure for buys and zero pressur...