Sell-Side Analysts’ Responses to Mutual Fund Flow-Driven Mispricing

Abstract

This paper illustrates the unique role of sell-side analysts in improving market efficiency by examining their responses to mutual fund flow-driven mispricing. We find that a select group of analysts persistently issue price-correcting recommendation changes for stocks subject to flow-driven mispricing while making little change to their concurrent earnings forecasts for the underlying firms, suggesting that their recommendation changes are driven by stock mispricing rather than cash flow-related information. The responses of mispricing-sensitive analysts appear to be skill related as they also tend to make superior stock recommendations and earnings forecasts in the past. Furthermore, fire-sale stocks upgraded and fire-purchase stocks downgraded by mispricing-sensitive analysts experience less liquidity deterioration and greater price correction immediately following analyst recommendation changes. Correspondingly, they exhibit smaller return reversals in the long run. Our findings suggest that mispricing-sensitive analysts play an important role in stabilizing the financial market.