Regulations Suppressing Analysts’ Earnings Optimism?

Have Regulation FD (Fair Disclosure) of 2000 and the Global Analyst Research Settlements of 2002 effectively removed incentives for sell-side analysts to curry favor with their own and covered company management teams by issuing inflated earnings forecasts? In their May 2008 paper entitled “Conflicts of Interest and Analyst Behavior: Evidence from Recent Changes in Regulation”, Armen Hovakimian and Ekkachai Saenyasiri investigate whether these two regulatory actions reduced the average analyst earnings forecast bias found in prior studies. Based on the annual earnings forecasts of sell-side analysts and associated actual annual earnings over the period 1984-2006, they conclude that:

• Over the entire 1984-2006 sample period, analyst earnings forecasts are optimistic. The mean forecast bias prior to Regulation FD equates to about 2% of the stock price. Mean forecast bias declines steadily as the earnings release date approaches, from about +3.3% for forecasts made 20 months before the end of the forecasted year to about +0.4% percent for forecasts made one month after the end of the forecasted year.
• Controlling for macroeconomic conditions and firm/analyst characteristics, Regulation FD reduces but does not eliminate the bias for optimism in earnings forecasts.
• After the Global Analyst Research Settlements:
  • Mean forecast bias falls sharply to +0.6%.
  • Median forecast bias disappears and exhibits no walk-down trend as the earnings release date approaches.
  • Results are not limited to the 12 banks covered by the Global Settlement, but rather are similar for all sell-side analysts.

In summary, Regulation FD and the Global Analyst Research Settlements helped reduce earnings forecast bias by neutralizing conflicts of interests for equity analysts.

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