In a recent investing column with the clicky title, “3 Stocks Even Wall Street Fat Cats Expect to Crash,” I asserted that Wall Street insiders are mostly in on the take. Among the proof: More than half of stocks in the S&P 500 have topped expectations every year since 1998, strongly indicating Wall Street sets low expectations that are easy to meet. Also, data from Factset shows that 54% of stocks covered by the so-called smart money get “buy” ratings, 42% get “holds” and a mere 4% garner a “sell.” Sounds like analysts are afraid to irritate the companies they cover with an honest assessment of their stock, don’t you think?
My theory was that, taking this information, a savvy investor can read between the lines and easily find stocks that are going to crash by simply listening to what Wall Street is mildly negative about. Considering the rose-colored glasses these “experts” are wearing, it seems logical that a moderate amount of displeasure in a company can be considered the loudest of alarm bells. (Read how even Wall Street admits that Eli Lilly (NYSE:LLY), Netflix (NASDAQ:NFLX) and Sears (NASDAQ:SHLD) are doomed.)
I’d like to pick up where I left off, however, after uncovering a fascinating read over the long weekend by Smart Money columnist Jack Hough. His assertion is a bit milder than mine: that analysts are flawed creatures, but investors can best put their commentary to use by following a few simple rules:
- Time is Money: “First, analyst recommendations are like dairy products in that it is best to use them quickly or not at all,” referencing a 16-year-old study in the Journal of Finance. “Shares tend to drift in the direction of recommendation changes, but for weeks or months, not years.”
- Sell Calls as Serious as Cancer: Dovetailing with my previous column about how Wall Street insiders are more or less in bed with the companies they cover, Hough quotes a former Goldman Sachs (NYSE:GS) exec who says, “Analysts face little resistance to their ‘buy’ recommendations but risk angering companies and investors with their ‘sells,’ so they tend to issue sell calls much more judiciously.” That’s a charitable interpretation of my previous column, but at least on point.
- Ratings Changes Should Be Tied to News: Perhaps the most valuable tip is how to decipher which “buy” ratings to pay attention to. The gist is that most experts can make math and momentum work however they want to for an upside target — but three analysts working on a soon-to-be-published paper on the nonsensical world of Wall Street ratings point out that the best targets are formed after new news comes to light. After all, changes in a product line or union contracts or supply chains would warrant a review of your target. It’s logical, of course. Why would someone throw out a significant change in price or change ratings on a stock without new information?
Let’s be clear here: Analysts are not your friends. They are imperfect, and no smarter than you or I — so investors placing undue importance on the “smart money” do so at their own peril.
That said, there’s nothing wrong with paying attention to what the buzz is on Wall Street so long as you know how to interpret it. These three tips are a good place to start.
Jeff Reeves is the editor of InvestorPlace.com. Write him at email@example.com, follow him on Twitter via @JeffReevesIP and become a fan of InvestorPlace on Facebook. Jeff Reeves holds a position in Alcoa, but no other publicly traded stocks.
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