The Impact Of Investor Sentiment On Sell-side Analysts' Earnings Forecast Optimism

Sell-side analysts act as important information intermediary in financial markets. They make stock recommendations and provide earnings forecasts for investors, which are important inputs in investors'decision-making. However, their earnings forecasts are found to be optimistically biased and are time variant with investor sentiment. In this paper, I examine the impact of investor sentiment on sell-side analysts'forecast optimism based on the 2005-2013 earnings forecasts data for A-share stocks, with investor sentiment both of the whole market and of individual and institutional investors included. I hand collect "Haodan index" and choose it as the proxy for the overall market sentiment. To measure individual and institutional investor sentiment, I use standardized newly opened stock accounts by individual and institutional investors. In contrast to current literature, my empirical results show that the stronger investor sentiment leads to more optimistically-biased earnings forecasts, and this effect is more significant on stocks with larger size, higher book to market ratio, lower dividend per share, and higher Leverage to asset ratio in Chinese stock markets. In addition, institutional investor sentiment has larger impact on analyst forecasts than that of individual investor sentiment.My results indicate that sell-side analysts track investor sentiment to make their earnings forecast. On the one hand, these analysts should be professional and independent; on the other hand, they need to generate investment banking and brokerage business for the brokerage firms they work. When investor sentiment is high, investors tend to overvalue the assets, and firms increase their activity of refinancing such as seasoned offering. At the same time, sell-side analysts are more likely to issue more biased forecasts to increase trading volume and attract potential investment banking business. Their biased forecasts do not affect their reputation as much when market participants are optimistic. I also document that institutional investors'trading volume are much greater than individual investors, and sell-side analysts'income are mainly generated from institutional investors'trading commission. Moreover, "star analysts" are elected by institutional investors, and it would be a great promotion to their future career development if they were awarded "star analysts". Therefore, sell-side analysts have more motivation to cater to institutional investors, or to track institutional investor sentiment. This study adds to the literature with the findings on the relationship between investor sentiment and analysts' earnings forecasts in an emerging market of unique institutional settings.