Teamwork: In-house economists make analysts more accurate

In periods of economic downturn, analysts’ forecasts are generally more optimistic than conditions warrant. On the other hand, analysts are very accurate reflecting positive signs. But new research shows that when analysts have access to an in-house economist, they are less likely to paint a rosy picture about discouraging news, making their work more valuable to investors.

Artur Hugon, a professor of Accountancy at the W. P. Carey School of Business, was drinking a cup of coffee and reading The New York Times one morning in August 2011 when an article on the front page of the business section caught his attention. Its title: “On Wall St., a Big Split on Outlook.” The article described how the research analysts who track individual companies remained “remarkably optimistic” even as economists were “ratcheting down” their growth forecasts. “I wasn’t sure that what The Times article was saying was true,” Hugon explains. “Were analysts over-optimistic during downturns? I decided to find out.”

Hugon and two colleagues looked at analysts’ forecasts of corporate earnings and compared them to companies’ actual earnings — to see how accurate the forecasts were. As it turns out, The New York Times article was right. In periods of economic downturn, analysts’ forecasts were generally less accurate: they forecasted better corporate results than actually occurred.

They were, in other words, overly optimistic about the results of the company they covered, in spite of the negative economic news. But as Hugon and his co-authors describe in a paper published recently in The Accounting Review, there are factors that can mitigate the tendency of analysts to be overly optimistic.  That’s important information for investors who look to forecasts from research analysts when making investment decisions. And it’s important for investment firms that rely on their reputation for “economic sophistication in terms of research credibility” to attract and keep big clients.

Over-optimism, but not the reverse

In their paper, “Analysts, Macroeconomic News, and the Benefit of Active In-House Economists,” Hugon and colleagues Alok Kumar of the University of Miami and W. P. Carey Ph.D. alumnus An-Ping Lin of Singapore Management University explain that while analysts don’t do a good job of incorporating negative economic news into their forecasts, they do fine incorporating positive economic news.

Why the bias against bad news? Hugon explains several potential reasons. Underlying all of them is the fact that analysts simply don’t have much incentive to go negative. Analyst research itself doesn’t generate revenue for the investment firm; it’s a way for the firm to start relationships with companies that will hopefully then hire the investment firm for such lucrative work as M&A advisory and underwriting. This builds momentum toward a positive outlook. “Analysts select to cover firms that they are optimistic about in the first place, since better-performing firms are more likely to (generate revenue for the investment firm),” Hugon and his co-authors write.

Furthermore, analysts know that investors are basing decisions in part on their advice, and it can be a “dicey position” for an analyst to turn around and deliver a negative forecast. As a result, analysts tend to deliver negative forecasts only when the economic evidence is irrefutable. “One of the macroeconomists I spoke with said that when the economic outlook was negative, analysts normally would go talk to management at the companies they covered, giving management a chance to explain how the negative economic outlook didn’t apply to them,” says Hugon.

In-house economists improve analysts’ accuracy

During periods of adverse economic news, Hugon and his co-authors found a key mitigating factor, one that consistently improves the accuracy of analysts such that their forecasts are much less optimistic: the in-house macroeconomist. “When analysts have access to an in-house macroeconomist, they underreact less to negative news,” Hugon explains. “That is, they have more accurate forecasts.” Hugon says that there is no way to observe empirically the specific interactions with an  in-house economist that lead to improved accuracy, but he and his co-authors float several potential reasons.

First, the economist serves as a voice of reason — “a source of evidence to the contrary against optimism in the face of a negative economic outlook.” Second, while all analysts have access to consensus economic forecasts through data providers such as Bloomberg, an in-house macroeconomist provides economic forecasts and outlooks that are revised with high frequency, often every day. These more detailed and nuanced forecasts help analysts  to discern the effects of the economy on specific industries and companies.

Third, in-house economists are available for one-on-one interaction with the analysts, to answer questions and provide additional context. That matters not only because of the additional insights that analysts can glean, but also because regular dialogue builds trust. The better the economist, the better the analysts’ forecasts. Hugon and his co-authors found that the benefit of an in-house economist was even stronger when the economist was award winning and/or had a track record of  delivering very accurate economic outlooks.

In-house economist as competitive advantage

Investors seem to understand that access to an in-house economist improves the accuracy of analyst forecasts. As Hugon and his co-authors explain, “Investors react more strongly to earnings research from analysts who have access to in-house macroeconomists.” That points to one of the key contributions that Hugon and his co-authors make with this research: having an in-house economist can be a competitive advantage for investment firms. “Our findings suggest that in-house macroeconomists not only play an important role in analysts’ forecast efficiency, but also influence the market credibility of analyst research.”

As Hugon explains, competitive advantage is ever more important for investment firms. “With increasing competition, investment firms have to figure out how to provide added value to their institutional clients. They can do that by leveraging their internal resources more. Whereas economists and analysts maybe worked in isolation before, now they’re working together to deliver higher quality output to those institutional clients.” So the bottom line for investment firms: hire an in-house economist and ensure collaboration with research analysts. And for investors, here’s another analyst credential to check: does the firm have an active in-house economist?

Bottom line

• Analysts don’t sufficiently account for negative macroeconomic news in their forecasts. (Though they do sufficiently account for positive macroeconomic news.)
• When analysts have access to an in-house macroeconomist, they underreact less to negative news. That is, they produce more accurate forecasts.
• The better the macroeconomist, the more accurate the analysts’ forecasts.
• Investors give more credence to analysts who have access to in-house macroeconomists. In other words, having an in-house economist can be a competitive advantage for analyst firms.