Incentives and market efficiency

The NYT's Joe Nocera writes about "the anguish of being an analyst," focusing on Prudential's Michael Mayo of Prudential:

Michael Mayo. . . . is one of the few Wall Street analysts who is willing to put sell recommendations on stocks when he thinks it is warranted. . . . [T]here are more sell ratings than there used to be. But there aren't nearly as many as there would be if research were truly reformed; Mr. Mayo told me that in the sectors he covers, buys still outnumber sells on the order of eight to one. . . . Stripped of investment banking revenue, research must rely on trading commissions to pay the freight, and commissions are under severe pressure. . . . Between the desire of corporate clients for favorable treatment and the lousy economics, the incentives to support independent research simply aren't there.

I suppose there are a number of solutions we could try. How about a minimum wage for securities analysts? Or maybe they could all go work for the SEC?  Or we could outlaw index funds.

Or we could try to understand the basic economics of the industry. The bottom line is that in an efficient market it's hard to generate a profit on research. As soon as you develop and use or disseminate information about securities, prices reflect it and the information becomes worthless. The copyright laws don't help you.

When brokerage commissions were fixed, brokerage firms could compete on research. But it's even more basic than that: investors shouldn't be buying individual stocks on the assumption they know something the market doesn't. That takes care of both retail brokerage and, to a significant extent, managed mutual funds. As I've said,

[s]ane [securities] regulations would focus attention instead on trying to convince investors that they should stay away. They should not be trying to analyze what companies say about themselves, and they should not suffer under the delusion that $20 bills are lying all over the place. They should be leaving investments to professionals or, better yet, index funds.

Yet research is what makes securities markets efficient. Thus the fundamental conundrum of the securities markets: investors should behave as if markets are efficient, but if they do, and don't buy research, markets won't be efficient. What to do?

We could start by understanding that the securities markets depend on people being able to capitalize the value of their information. So let people trade on nonpublic information as long as they don't steal it. Nothing is worse for the securities markets than the futile quest for "equal" access to information.

The SEC already regulates takeover information. The misguided Reg FD squelches disclosures by companies to analysts which, as I've said, "interferes with corporations’ and analysts’ incentives to produce and disclose information."

And there's talk of even more broadly regulating "outsider" information. As discussed yesterday, Bruce Kobayashi and I have a paper on that, and you can imagine by now what it says.

Nocera specifically discusses the problem of inadequate sell recommendations. In efficient markets, analysts have to get the crumbs where they can, and they're falling from the tables of the firms that want to sell securities, not buy them.

One solution is to encourage short-sellers, not attack them.

Bottom line: if we want efficient markets, we need to understand how to get there. It's all about incentives.

Comments

[Marc Hodak]

Gosh, I feel so bad for those poor analysts. And how on earth will the market know what to buy or sell without six or eight inidividuals in New York or London telling them what to do?

[Marc Hodak]

By the way, I finally got rid of my subscription to the NYT this week. I no longer find their articles entertaining. (And it's been many years found them informative.)

[Robert Schwartz]

Sell side analysis was always worthless. That is why the brokers could not charge for it. As you said, buy side is only worthwhile if you keep your mouth shut and trade underneath the noise level.

[Marc Hodak]

Sell side analysis was actually very good, as analysis, which is why the buy side used it. Intelligent investors had long ago given up paying attention to the "buy" recommendations attached to the analysis. I don't get why the IBs have persisted in attaching those pointless recommendations. Only ignorant investors take them seriously, meaning the IBs continue to expose themselves to the credulous reliance of their least sophisticated investors.