Impact of Analyst Recommendations on Stock Prices

(ProQuest: ... denotes formula omitted.)IntroductionThe efficient market hypothesis propagated by Fama (1970) states that a market in which the share prices fully reflect all the available information about a firm is said to be an efficient Fama (1970) then went on to classify the markets into three different types, depending on the type of information reflected by the prices in the market: weak form-reflecting only historical prices; semi-strong form-reflecting the historical prices as well as any other publicly available information such as the earnings, dividends, and stock-splits; and strong form-which reflects all information about the company, historical prices, and publicly as well as privately available information.It is commonly found that brokerage houses and analysts spend a considerable amount of time doing research on the information available about the firms, and hence are believed to have superior stock picking as well as market timing abilities. Though, if markets are semi-strong form efficient, then all publicly available information should be reflected in stock prices. Analyst recommendations should have no material impact on stock prices and, hence, should not facilitate abnormal returns for the investors.Many investors continue to rely on the analyst recommendations, as they may not have the time or expertise to analyze the available data. Also, in many cases, obtaining the data itself may be expensive and out of the reach of many retail and small investors. In the case of analysts, they interact closely with the firms they are analyzing and are privy to information that may not be available to retail investors.Investors are willing to pay compensation to the analyst's firm as they expect a profit from its recommendations which is higher than the cost of advice. A logical source of benefit for an investor would be excess stock return he could earn following broker recommendations. But how reliable and accurate are these recommendations? Can an investor make profitable investments on the basis of these recommendations or are they already anticipated and their impact nullified, as should happen in a semi-strong form of market?Studies in this area have been limited to the developed markets such as the US, the UK, Germany, Italy, Australia, Hong Kong, and Sweden. The studies related to the emerging or developing economies are far and few. The Indian capital market has shown incredible growth1 in the last few years. Indian investors have become more informative and mature. Many financial institutions provide company stock analysis with the purpose of providing useful information to their clients. Over the years, as the Indian financial markets have evolved to become more transparent and professional, the role and recommendations of stock analysts and brokerage houses have become increasingly crucial. The number of brokers2 in the Indian financial markets has increased considerably over a period of time.This motivates us to study the impact of analysts' recommendations on stock returns in Indian capital markets. This study examines whether investors can exploit analyst recommendations available on a public website like www.rediff.com for making abnormal returns.Literature ReviewAnalyst forecasts have attracted the attention of many academic researchers for a long time. Cowles (1933) studied whether stock market forecasters could forecast the market or stocks they focus on. The conclusion was that they could not.Grossman and Stiglitz (1980) pointed out the impossibility of informationally efficient market. Their argument was pretty straightforward: if the market prices capture all information about stock price, then no one would be researching stocks (since that involve costs in terms of time and effort) but rather accept the market price as the best estimate of the real 'value' of the stock. Another study by Menendez-Requejo (2005) on the Spanish stock market states that there is no possibility of significant abnormal return on the day of recommendation or the following day, while there is a possibility of abnormal return the day before the recommendation. …