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Analyst Recommendations as an index of Investor Sentiment?

Othman Alolah
Pedro Aguerreberry

Department of Finance
University of Tampa

July 2015



It is to the surprise of no one that recommendations made by investment

analysts can influence and nudge securities investors in certain ways. Those
analysts are perceived by investors to have both extensive market experience and
sophisticated kit-tools that enable them to produce their stocks recommendations.
According to (Jegadeesh and Kim) (2009), large brokerages analysts and analysts
that revise their recommendations less frequently are more likely to herd investors.
(Womack) (1996) showed that there is strong evidence that stock prices are
significantly influenced by analysts' recommendation changes, not only at the
immediate time of the announcement but also in subsequent months. Moreover,
(Loh and Stulz)(2010) observed that investors substantially changed their
assessments and valuations of a firm after some analysts changed their
recommendations of the firm. Therefore, if investors, in a largo scale, followed the
recommendations made by analysts, we argue that analysts' recommendations can
surly be used as an indicator of the investor sentiment, or the market-mood.
We think of investor Sentiment as beliefs about future cash flows and
investment risks that are not rationally justifiable considering the information
available to the investor. The importance of conducting research about investor
sentiment is shown by the fact that there are numerous studies in support of the
idea that investor sentiment affects asset valuation and earnings expectations. Both
(Statman)(2000) and (Baker and Wurgler, Investor Sentiment and the Cross-
Section of Stock Returns)(2006) documented the importance of investor sentiment

as a factor of the market pricing process. Also, (Charoenrook)(2005) found that

changes in consumer sentiment are a strong economic and statistical predictor of
returns compared to other known market return predictors.
Scholars have created many sentiment indices employing different factors. A
number of these indices employ Internet and media content to try and capture the
investor sentiment at a certain time. For instance, (Tetlock)(2007) found that high
levels of pessimism showed by media produced a downward pressure on market
prices, and that unexpected low or high levels of pessimism led the trading volume
temporarily to be high. However, and to our knowledge, none of sentiment indices
in the literature have used analysts' recommendations as the base of the index.
The purpose of this paper is to introduce a new market sentiment index to
measure optimism (greed), pessimism (fear) as a predictor of market returns. We
argue that the proposed sentiment index could predict some asset-pricing
movements that are not explained by fundamentals. Our study provides an
empirical link between evidence on analyst recommendations, individual decision-
making, market sentiment, and stock market returns. It also helps promote an
understanding of the analyst industry as well as its influence on the investing
population. We expect this study to provide evidence in support of our hypothesis
that analyst recommendation, as a base on investor sentiment index, is likely to be
the most accurate variable to measure and explain markets sentiment. We
anticipate that our index outperforms some other sentiment indices predicting
abnormal returns and some of the market movements.


There are several investors sentiment indices developed in the last two
decades but none of them incorporate the powerful influence exerted by stock
analysts. Thus, this index could provide a powerful tool to explain and predict
security returns. Analysts make their recommendations based on reviewing the
macroeconomic scene and the firm-specific financials and other non-economic
variables such as management team changes, potential scandals. Therefore, we
argue that analysts recommendations have incorporated the most relevant
information that captured the value of a security, and thus, it represent an
interesting base of the suggested investor sentiment index.


The proposed index reflects the opinions of market experts who influence
investors through platforms such as news media and Internet websites. Past
Research have proved that recommendations that were passed through media and
Internet surly affect investors sentiment and market behavior. (Trahan and
Bolster)(1995) examined the impact on stock prices of purchase recommendations
published in Barron's publication. Their examination showed a positive and
significant short-term impact on stock prices at the time of publication. According to
(Tetlock)(2007), high levels of pessimism showed by media produced a downward
pressure on market prices, and that unexpected low or high levels of pessimism led
the trading volume temporarily to be high. (Arnold, Earl, and North)(2007) confirm
that positive stories generally indicate the end of superior performance and

negative news generally indicates the end of poor performance. They also confirm
that outperforming companies do not continue to outperform, and that they
perform equivalently to an industry matched Peer Company after the cover story or
recommendation appears. (Loh and Stulz)(2010) showed that investors
substantially changed their assessments and valuations of a firm after some analysts
changed their recommendations of the firm.
Analyst recommendations contain market and industry-level information
about future returns and earnings that are indeed helpful when making the
investment decision. According to (Green)(2006) brokerage firm clients obtain an
incremental investment value in the form of a short-term profitability.
(Welch)(2000) showed that the buy or sell recommendations of security analysts
have a significant positive influence on the recommendations of the next two
Early access to recommendation changes by purchasing upgrades and by
selling short downgrades yields positive returns. For example, (Womack)(1996)
finds that positive (negative) abnormal returns are correlated to upgrades
(downgrades) in analyst recommendations right after are announced. (Howe, Unlu,
and Yan)(2009) found that changes in aggregate analyst recommendations forecast
future market excess returns after controlling for macroeconomic factors. Moreover,
the authors provide evidence that changes in industry analyst recommendations
predict future industry returns. Obviously, past literature is rich with studies that
support the hypothesis of analysts recommendations spread through media and

such communication channels affecting and nudging the investors behavior in the
stock market.
In assets-pricing literature, traditional researchers have used variables that
are related to firm-specific and macroeconomic variables. However, in the last
decide, scholars have increasingly employed some psychological variables as
investor sentiment to try and determine asset prices. (Baker and Wurgler, Investor
Sentiment in the Stock Market)(2007) define a sentiment index as a linear
combination of six variables: the closed-end fund discount, the logarithm of the
NYSE share turnover ratio (trended by the 5-year moving average), the number of
IPOs, the average first-day return on IPOs, the share of equity issues in total equity
and debt issues and the dividend premium, defined as the log difference in the
average market-to-book ratios between dividend payers and non-payers.
Our suggested sentiment index can be tasted as determination tool for asset
prices. We also try to find strategies to exploit anomalies that generate abnormal
returns. Thus, we created a new market sentiment index to predict returns.
According to (Brown and Cliff)(2005), if excessive optimism drives prices above
intrinsic values, periods of high sentiment should be followed by low returns, as
market prices revert to fundamental values. (Brown and Cliff)(2005) also found that
future returns over multiyear horizons are negatively related to sentiment.

Following the steps of many research papers in past literature, we propose to

retrieve empirical data from Zacks database. The data used will cover the period

from 2004 to 2014. The population includes all recommendations issued to

companies that are part of the Russell 3000 Index, which is more inclusive of small
caps than the S&P 500. This index measures the performance of the largest 3,000
U.S. companies. The information comprises recommendation date, brokerage house
issuing the recommendation and the analyst writing the report and a rating
between 1 and 5. A rating of 1 reflects a strong buy recommendation, 2 a buy, 3 a
hold, 4 a sell, and 5 a strong sell.


The proposed methodology estimates the bullish/bearish spread based on buy/ sell
recommendations ratio. Average aggregated recommendations considering all
publicly traded stocks from the Russell 3000 are calculated quarterly following the
schedule of corporate earnings reports. New and revised recommendations, which
were issued less than 12 months ago, are counted equally for the purpose of this
We constructed five portfolios to determine if a profitable strategy exists based on
market sentiment made with aggregate analyst recommendations. We intend to
compare the market sentiment from same quarter in previous year to measure
realized returns using a regression analysis. This method would provide with a
significant and direct correlation between variables.
We also plan to perform a validation analysis using a three-factor model (Fama, et.
al, 1992). We would incorporate market sentiment to the cross-section regression
analysis performed by Fama-French to evaluate the index performance using the

three-factor model (Fama, et. al, 1992). The variables include market premium to
measure quarterly excess return to the cap-weighted Russell 3000; Small caps on
the basis of market capitalization; Stocks ranked quarterly on the basis of book
value-per-share to market price-per-share ratio. We would perform a regression of
quarterly excess returns on the three variables described above regressing them to
returns based on market sentiment. We expect a positive market sentiment would
outperform stocks in a negative market sentiment.

Table 1: Example of Aggregate recommendations










# Avg.








> 5%





















< 1%








Note: Bearish market sentiment should not be confused with a correction, which is a
short-term trend.


Table 2: Expected Return on the S&P 500 based on Market sentiment

R. Rating

Market Sentiment
S&P500 Expected Returns Range



1 (strong buy)



2 (buy)



3 (Hold)



4 (Sell)



5 (Strong Sell)



The following indicators may provide additional information to the main Sentiment
index described in this paper.
The CBOE Volatility Index (VIX)/ Put and Call Options volume
Bond/ gold Demand
Number of short positions
Spread between AAA and junk bonds
Stock Price Breadth (advance/decline line)
Number of stocks hitting 52-week lows
Number of IPOs
Price Dividend Ratio (above 26 may signal overvaluation)


We expect to see a higher return on stocks with positive analyst recommendations,

small size, and high book-to-market ratios. We believe that a positive market
sentiment followed by a positive stock recommendation will a) accelerate the
increase in expected return; b) maintain momentum for a longer period; and c)

overvalue stocks based on fundamentals. Additionally, a negative market sentiment

followed by a negative stock recommendation will a) accelerate the downfall in
expected returns; b) shorten momentum; and c) start reverting to the mean
The increases in the expected returns due to positive markets sentiment are more
frequent because of the existence of a behavioral bias toward over-optimism
observed by Clayman and Schwartz (1994). This optimism may inflate prices above
fundamental value. An investor would be better off purchasing shares in firms with
more favorable consensus recommendations and selling shares in those with less
favorable consensus ratings (Barber et. Al, 2001)


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