San Diego State University

CHANGES IN ANALYST RECOMMENDATIONS are significant events reported to investors and are often accompanied by analyst interviews and comments. Despite long-running doubts regarding their expertise and motives, they remain the high priests of equity performance prediction.

My new study with Mario Ramos at San Diego State University shows the emperor has no clothes. We examined the accuracy of analyst recommendations from the point of view of the individual investor. Analyst performance was studied for the Dow Jones Industrial Average and the Standard & Poor's 500 over a seven-year period beginning in January 1998 and ending in December 2005. In both studies, the performance recommendations were tracked from their initiation to their termination.

Results were sobering. The average net performance of Dow Jones Industrial Average stocks with Buy, Hold and Sell ratings was 1.0%, 2.4% and 2.0%, respectively. The results for the S&P 500 technology sector were worse. Statistically, stocks with Buy ratings underperformed stocks with Hold and Sell ratings. The average net performance of stocks with Buy, Hold and Sell ratings was 4.4%, 7.9% and 8.3%, respectively.

Although harsh, one may conclude from these findings that, as a whole, the analyst community either has no real stock-picking expertise or they have expertise, but they have been corrupted by conflicts of interest. The Sarbanes-Oxley Act was supposed to deal with conflict of interest issues, but results from this study suggest it has failed. Our analysis examined whether the accuracy of analysts' predictions improved after Sarbanes-Oxley was passed. At least through the time period of the study, Sarbanes-Oxley had no impact on accuracy. If anything, analyst's performance deteriorated.

What can be done? The Federal Trade Commission established three criteria to assess deception: likelihood, materiality and reasonableness. Consumers can be deceived not only by what is in an appeal or representation, but also by what is omitted, particularly if the omitted information is important to understanding its implication. The fact that recommendations are worthless is certainly a piece of omitted information that could be helpful to investors.

The FTC is likely to infer the materiality of omitted information if the purveyor of that information knew or should have known that consumers needed the omitted information to evaluate the product or service.

The third FTC criterion is reasonable consumers. The reasonable standard is generally presumed to be met if the practice has the capacity to mislead 20% to 25% of the targeted group. Our follow-up research with more than 700 individual investors with online-trading accounts indicates that 51% of the respondents reported being influenced by analyst recommendations at least some of the time. Seventy-one percent and 85% of respondents at least moderately agreed with the statement that stocks with Buy ratings outperform stocks with Hold ratings and Sell ratings, respectively.

A recent Supreme Court ruling, Roberts v. the FTC (2002) opens the door to the FTC's involvement in the securities industry.

If now is not the time to look at this issue, then when?

-- William E. Baker, PhD, professor, marketing

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