On April 6th, the Wall Street Journal printed a story citing sources who said that a JP Morgan trader known as the “London Whale” had an extremely large trading position that motivated some hedge funds to act opportunistically at the expense of JP Morgan Chase and Co.

On April 13th the CEO of JP Morgan, Jamie Dimon, was confident that the mysterious “London Whale” trader posed no real threat to his bank. The story, he said, was “a complete tempest in a teapot.” Perhaps he was too confident – some would say overconfident – because one month later, after trading losses were confirmed, JP Morgan’s stock price fell 19 per cent; collapsing quicker than a teenager at the opening of a K-pop concert.

While the fall was dramatic it wasn’t the tragic part of the story. Nor was the tragic part of the story Dimon’s fall from grace.

At his peak, Dimon was an aggressive and vocal critic of financial regulation. He was also no ordinary bank CEO; he was referred to as a risk management wizard – an outstanding leader who was able to guide JP Morgan away from the fire that ignited the Global Financial Crisis. But by denying his bank’s risk exposure, he became the prime example of a man who financial regulation was supposed to save from himself.

No, the tragic part of the story was not the failure of Jamie Dimon – the tragic part was the failure of the financial analysts covering JP Morgan.

Too supportive

To be clear, most of us are too busy with our day-to-day lives to try to figure out whether a CEO of an invested company (or a too-big-to-fail bank) is overconfident or negligent. We outsource that activity to scrappy individuals called financial analysts who are supposed to be part bulldog (tough), and part grandmother (supportive). In reality, analysts are too nice and too supportive of CEOs. Analysts maintain positive recommendations and optimistic earnings forecasts even when the truth is that the company is unimpressive.

ThinkAloud4However, the case of JP Morgan is a special one for financial analysts. On May 10th, the world knew that Dimon was wrong.

The investing public did not need financial analysts to tell us that he was wrong about the London Whale, wrong about his risk assessment, and possibly wrong about financial regulation. It was obvious that he was wrong, but it was also obvious that most financial analysts who covered JP Morgan did not change their recommendations to reflect the idea that the CEO was overconfident.

Only one analyst out of the 14 who were part of the original conference call downgraded the stock; the downgrade was from ‘Buy’ to merely ‘Outperform.’ It was only on July 29th that another analyst from the original call downgraded the stock to an unthinkable ‘Hold.’

Those who say that the trading loss was not that large relative to the firm’s earnings are missing the point. The point is that the CEO was overconfident and clueless with respect to his bank’s activities. The stock price fell not because of the bank’s loss, but because of the bank’s leader. At the same time, analyst recommendations did not reflect the idea that the bank appeared to be run by an overconfident leader.

Meanwhile, those who say that analysts are only factoring in the loss and not the leader are also missing the point. Since the Q1 conference call, financial analysts have been asking more pointed questions of Dimon. That is, they probably think that he had perjured himself and tarnished his reputation.

Moreover, they probably think that JP Morgan’s earnings going forward are likely to be unimpressive if the CEO is an overconfident blowhard. If the analysts had been forced to tell you the truth, then they would have downgraded the stock in line with the precipitous fall of the stock price in May. So why didn’t they?

Truth test

The answer can be explained in one short sentence: Analysts are not paid to tell you the truth, and not because you can’t handle the truth. For analysts who are compensated by brokerage firms, their compensation is highly correlated with brokerage commissions, and analysts know that investors are more likely to buy stock than they are to short stock.

Hence, as an analyst, that overconfident blowhard of a CEO is your friend.

There is an easy way to figure out whether analysts are telling the truth about their earnings expectations. You need only observe their forecasting behaviour over the firm’s reporting cycle. Fiscal year after year, quarter after quarter, financial analysts, on average, systematically reduce their earnings forecasts as the date of the firm’s earnings announcement approaches.

Therefore an analyst is more likely to be forecasting above true expectations when the firm’s earnings announcement date is further away in time.

There is also an easy way to tell whether a CEO is overconfident. If the CEO’s stock options are deeply in the money and the CEO does not exercise them, then he or she is probably too confident about his or her ability to increase firm value.

My own research (available at http://ssrn.com/abstract=1955878) uses analyst-forecast and CEO-compensation data for the years 1992 to 2009 to shows that when the CEO’s stock options are deeply in the money, then analysts make forecasts earlier in the firm’s reporting cycle.

The finding is consistent with the idea that analysts are too optimistic when CEOs are overconfident. So if Jamie Dimon has indeed lost his star power, then you are not going to figure it out by following starry eyed financial analysts.