Sometimes the gains from a new regulatory regime are obvious. The creation of the Federal Deposit Insurance Corp. is a perfect example. Your bank deposits are guaranteed by the government up to some stated amount, no matter the recklessness or irresponsibility of the bankers running the place. It wasn’t always this way. Before the FDIC, bank runs were common and depositors could and did lose all their money. The changes were an enormous improvement, allowing people to safely deposit their cash without fear of a run on the bank in times of trouble. Savings increased, stress over bank accounts fell, bank lending rose. The entire economy benefitted. It was pretty hard to misconstrue the impact: a win-win-win.
In the late 1990s and early 2000s, a series of scandals led to major regulatory changes in how Wall Street analysts did their jobs. A brief litany of related outrages would have to include: the WorldCom and Enron accounting scandals; manipulation of initial public offering pricing; private calls to larger investors that gave them an unfair advantage on the timing of analyst upgrades and downgrades; and slanted analyst reports on companies in order to winning investment banking business. A series of investigations by the Securities and Exchange Commission led to improved corporate disclosure underRegulation Fair Disclosure in 2000 and Congress passed the Sarbanes-Oxley Act in 2002, laying out rules on financial reporting, corporate governance and auditing. On top of that, in 2003 the state of New York forced Wall Street to clean up the way their analysts did business, clamping down on the conflicts that led to biased research and forecasts.
The net result of these regulatory changes? Analysts are now honestlywrong, instead of being dishonestly wrong.
You may shrug that off as no big improvement — wrong is wrong, after all. But it means that individual investors are no longer being duped by analysts and investment banks.
When it comes to market confidence, fairness is a big improvement.
I was reminded of this issue recently by a new study accepted for publication by the CFA Institute’s Financial Analysts Journal titled, “Did Analyst Forecast Accuracy and Dispersion Improve Following the Increase in Regulation Post 2002?” by Hassan Espahbodi, Pouran Espahbodi and Reza Espahbodi.
As Bloomberg News reported:
More than a decade after a government crackdown on conflicts of interest on Wall Street, a new study says stock analysts are no better now than they used to be at predicting corporate earnings. Actually, they’re worse, according to the paper, which reviewed how close profit estimates came to what companies ended up reporting from fiscal year 1994 to 2013.
Perhaps you forgot what it was like in the 1990s. It was a time of madness, an era of dizzying market gains and a full-on technology bubble. As is their wont, unsophisticated individual investors decided to jump in with both feet late in the cycle. I look at the 1995 Netscape IPO as the turning point where the public seemed to have lost its head over equity trading. This was after prices had already risen a lot and price-to-earnings ratio were looking rich.
Investment bankers saw a market hungry for new issues. They fulfilled that demand. There is nothing wrong with selling IPOs to those who want them; all of the basic securities laws still applied. But there were enormous loopholes that allowed all sorts of inappropriate behavior and misleading marketing. To restore public confidence in financial markets and to increase a sense of fairness, those new rules and laws were passed.
Reza Espahbodi, one of the authors of the aforementioned report, and a professor at Washburn University, states the obvious: “Even though conflicts of interest are being reduced because of rules, we’re still back to square one because we don’t have accurate forecasts,” he told Bloomberg reporters Joseph Ciolli and Oliver Renick in a phone interview.
To draw that conclusion is to miss the point. You can’t regulate accuracy in forecasts. After all, that is what analysts do — they make educated guesses about how a company, industry or the economy might perform in the future.
That nobody does this consistently well isn’t a failure of regulation; rather the matter represents a fundamental misunderstanding of human capabilities. As we have detailed so many times before (seethis, this, this, this, this, this, this, this, this and this), people are terrible at making predictions. That they keep trying is a testament to both persistence (a good trait) and foolishness (a not so good trait).
Regardless, there have been enormous changes forced on research departments everywhere. The results are somewhat mixed. Research is a much less profitable business than it once was, a result of numerous factors, including (but by no means exclusively) the new regulations. However, the research departments of investment banks are no longer selling one group of clients down the river for the benefit of another group of clients. That was more or less the earlier state of affairs.
More than 10 years after the big Wall Street analyst settlement, the analyst community isn’t any better. And when forecasts are wrong, it probably isn’t because analysts are corrupt or cheating or favoring one group of clients over another. It is because of the preposterous job requirement that they say what will happen in the future.
It would be great if analysts were correct. If they can’t achieve that — and they can’t — at least they’re honestly wrong now.
Originally: Wall Street Analysts, Honestly Wrong at Last