Market Reactions to Messages from Brokerage Ratings Systems

One dimension of the strategies investment houses use to present investment advice is the number of categories in their rating systems. We studied three-, four-, and five-level systems and found that in all rating systems, upgrades outnumber downgrades. Price reactions are more pronounced to multiple-level than to single-level recommendation changes and to recommendation upgrades to the highest rating category. These price reactions confirm that the market gleans new information from analysts' research but suggest that investors, at least partially, recognize analysts' tendency toward optimism and thus react more strongly to downgrades. The price effects also show that adding more rating categories is not simply a way to portion out information in smaller bits. Some of the largest price reactions are to changes between the top two categories in a five-level system, even though the descriptions of the categories would not signal a portfolio action. Our results are consistent with the view that firms try to avoid issuing harshly worded recommendations, which might compromise revenue generation. A system with more rating categories provides for less-direct statements of bad news.