Analysts

Wall Street relies on “stock analysts.” These are people who do research on companies and then, no matter what they find, even if the company has burned to the ground, enthusiastically recommend that investors buy the stock. They are just a bunch of cockeyed optimists, those stock analysts. When the Titanic was in its death throes, with the propellers sticking straight up into the air, there was a stock analyst clinging to the railing asking people around him where he could buy a ticket for the return trip.

Dave Barry
February 3, 2002

When I was a broker many years ago a large number of things used to fascinate me about the industry. Everything from how come the guy sitting next to me was selling shoes last week and who thinks a trend is the move from sandals to sneakers. To why do analysts get paid so much when the used to suffer from what we used to refer to at uni as the elbow–posterior error chain.

Interestingly enough I was not the only person fascinated by the behaviour of analysts and fortunately for everyone else the task of looking at analyst’s behaviour has became a topic of study for people smarter than me.

The most intriguing part of analyst behaviour has been their consistent bias toward the long side of trading. Traditionally analysts have ranked their recommendations along the lines of strong buy, buy, hold, sell or strong sell. Occasionally in the mix you would get the recommendation switch, this was a favourite among brokers because it meant that you could pick up two lots of commission for reading a single piece of the script provided by the analyst.

Brian Bruce in his editorial comment in The Journal of Psychology and Financial Markets (2002, Vol 3, No 4, 198-201) has collated much of the material relating to the structure of analysts recommendations. In reviewing the data he found two interesting pieces of research. Thompson Financial/First Call found that 50% of all recommendations were buys whereas only 1% were sell recommendations. Zacks Investment Research reviewed over 8,000 recommendations for stocks that make up the S&P 500 and found that only 29 were sells. That’s about 0.33% of all recommendations.

The question that naturally arises from such data is why is there such a bias in the recommendations even in the face of overwhelming market evidence to the contrary. The answer as you would expect from the finance industry is greed. Issuing positive recommendations for companies has two effects. Firstly it allows the analyst easy access to the company, this access has a positive impact on an analysts career. Secondly positive recommendations generate corporate business for the broking firm. The fees that arise from this style of business are vast.

So where does this conflict of interest place the retail client, unfortunately the retail client doesn’t enter into the equation.

As Bruce so accurately puts it “An investor might expect advice that is free of both psychological bias and self interest. Instead they discover belatedly that the advice is a mixture of wishful thinking and self- serving hype.