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From the Street and academe, analysts meet to figure out the market

Yale finance professor William Goetzmann. By Justin Allardyce Knight Photography

If you think the past year's Wall Street scandals exposed the handful of scoundrels pushing weak stocks on small investors, then think hard about the following data, from Dartmouth finance professor Kent Womack. Womack, who spoke at a conference sponsored by the Carroll School's finance department on June 10 in Higgins 300, studied the actions of hundreds of stock analysts from more than two dozen brokerage firms between 1995 and 2001. He found that the analysts issued buy recommendations 67 percent of the time, hold recommendations 30 percent of the time, and sell recommendations 3 percent of the time. Wall Street had plenty of scoundrels, it seems.

At the conference, this point was underscored by a paper delivered by another academic Wall Street watcher, accounting professor Richard Sloan, of the University of Michigan. Sloan's paper, which bore the blunt if congested title "Pump and Dump: An Empirical Analysis of the Relation between Corporate Financing Activities and Sell-Side Analyst Research," considered accusations that stock analysts, under pressure from the investment banking branches of their own firms, hyped stocks of corporations that were planning to issue new equity shares. These new issues, known as IPOs, or initial public offerings, generate enormous fees for the investment banks underwriting them.

Sloan, an amiable gent with a blond pompadour and a clipped Aussie accent, started with the anecdotal evidence, the infamous e-mails in which stock analysts such as Jack Grubman, late of Salomon Smith Barney, admit, even boast, that they're touting dogs; the stories of investment bankers promising favorable stock ratings as part of their pitch to prospective IPO issuers; the compensation schemes where analysts' pay is tied to investment banking profits; and so on. This troubling evidence aside, Sloan conceded that previous researchers had found very little difference between ratings of the stock of Corporation "X" by analysts whose firms had investment banking deals with the corporation and ratings of the same stock by analysts whose firms had no such deals.

But the previous studies, Sloan contended, were all "turning the wrong dial," because when an issue of new equity is in the offing, all brokerage firms come under pressure to hype the stock. Why? As Sloan put it, "If a company is raising investment capital, you don't want to spoil their party, because sometime in the future [their bank] may come around and spoil your party."

Sloan's study results, in the form of 24 graphs and six tables of statistics displayed via PowerPoint, seemed to indicate that he and his coauthors were turning the dial that mattered. The visuals showed that for stock analysts across the spectrum, long-term forecasts of a corporation's earnings growth peak in the month or two before an IPO by the corporation; so does the degree of error in the long-term growth forecasts. The same went for the analysts' target prices—that is, their predictions of what a stock will cost a year and two years in the future—which, according to Sloan et al., have proven to be 80 percent too high for corporations doing IPOs but only 20 percent too high for other corporations.

If the conference attendees—some 80 professors, graduate students, and industry suits—believed Sloan was being too hard on Wall Street, nobody ever voiced that belief, nor did anyone even appear surprised by the paper's somewhat depressing conclusions.

In addition to Sloan's paper, another conference high point was the sweeping indictment of a whole academic subdiscipline by one of the aforesaid industry representatives, Richard O. Michaud, president and chief investment officer of the Boston firm New Frontiers Advisors. The targeted subdiscipline, behavioral finance, discards the classical economic view that markets are perfectly rational and uses the methods of psychology to explain odd behavior like the 1990s boom in the stock of unprofitable dot-com start-ups. Michaud argued that behavioral finance disciples ignore obvious rational explanations for the behavior they're trying to account for; that they study sample periods when their explanations work and ignore other periods when the explanations fail; and that their findings have "little investment value"—that is, you can't make any money from them.

Yale finance professor William Goetzmann, a sometime practitioner of behavioral finance, attempted a defense, saying he understood Michaud's concerns but that academics have to look at things beyond investment value, such as "what we can learn about the world." Behavioral finance, Goetzmann went on, is "an honest intellectual endeavor" that is barely 10 years old and may yet have "implications for practical decision making."

"If you're willing to say that behavioral finance has no practical implications . . . I'm willing to accept that," needled Michaud, which pretty much ended the conversation.

Michaud's presentation, along with Sloan's, was among the most accessible of a conference that featured screen after screen of complex equations, terms like "the Herfindahl Index," and utterances like this one: "Both return premia result from covariation with a priced-risk factor. . . ." And this one: "We estimate the betas for each test asset from simple returns using Ibbotson's sum-beta methodology with one lag. . . ."

"Does it mean anything for my 401(K)?" a non-expert observer might have asked—the same kind of question Michaud was posing in his rhetorical assault on behavioral finance. The answer would be a conditional yes, given lots of patience and careful listening.

Sloan's paper, of course, had a simple but important message for the small investor: Caveat emptor, especially when it comes to Wall Street types bearing free advice.

Meanwhile, a study by Harvard's Ken Froot and a collaborator, which Froot presented solo at the conference, found that a stock's style category—foreign or domestic, large cap or small, value or growth—affected the stock's price over and above the stock's fundamentals as reflected in accounting data. Froot, though, wasn't sure whether this effect came from rational, empirically based beliefs about the future performance of stocks in a given category or from irrational behavior, such as following the current rage for one or another kind of stock.

And then there was the paper by Dartmouth's Womack. While Womack and his collaborator didn't take at face value the buy and sell signals emanating from Wall Street, they did take a close look at changes in the signals—upgrades and downgrades in analysts' ratings of a stock—from "buy" up to "strong buy," for example, or from "buy" down to "hold" or "hold" down to "sell." Then they constructed a hypothetical portfolio that buys upgraded stocks and short-sells downgraded ones. The portfolio made hypothetical money, quite a lot of it. Lots more, anyway, than their other hypothetical portfolio, which simply followed the analysts' buy and sell signals, and barely made any money at all.

But, to take full advantage of the upgrade/downgrade strategy, an investor would have to sell off most of his or her holdings every month or so, replacing them with new stocks and new short positions based on the latest upgrades and downgrades. Considering the high cost of stock transactions, this looks like an expensive proposition. Expensive enough to wipe out the gains from the novel investment strategy? Hard to say, admitted Womack. He hadn't gotten around to that calculation.

David Reich


David Reich is a freelance writer in Boston.

 

Photo: Yale finance professor William Goetzmann. By Justin Allardyce Knight Photography


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