Investor beware: don’t buy into the irrational exuberance of market analysts

Studies of share performance indicate most investors would be better off tossing a coin

Taking stock: investors should establish if a banking relationship exists between an analyst and the company being assessed. photograph: spencer platt/getty images

Taking stock: investors should establish if a banking relationship exists between an analyst and the company being assessed. photograph: spencer platt/getty images

Tue, Dec 10, 2013, 01:05

There’s an old Wall Street joke that you don’t need analysts in a bull market and you don’t want them in a bear market – a sentiment many Irish investors, still raw from the decimation of bank share prices, will share.

But what does the research say? Do analysts move share prices? Should earnings forecasts and price targets be taken seriously? Or do analysts even care if their forecasts are wrong?

Target prices
Analyst reports can contain important points but should you take stock-price forecasts seriously? No is the answer. An analysis of 100,000 12-month stock-price forecasts made between 1997 and 2002 found prices were either at or above the target price on just 26 per cent of occasions.

Prices hit the analyst target at some stage during the 12 month-period on just 35 per cent of occasions. On average, actual prices were 35 per cent below the target price.

Not all analysts believe in such forecasts. GMO analyst James Montier scoffs at “pointless forecasts” and argues analysts should “return to doing as their name suggests: analysing, rather than trying to guess the unknowable”.

Analysts make directional market calls all the time but how often do they get it right? About 47 per cent of the time, according to the CXO Advisory website, which graded 6,459 public forecasts made between 1998 and 2012 – slightly worse than chance.

One of the more famous market timers, Marc Faber, often credited with predicting the 1987 market crash, exactly matches the overall accuracy rate of 47 per cent. Another high-profile forecaster, Goldman Sachs’ Abby Cohen, comes in at just 35 per cent. Worst of all, at just 22 per cent, is Robert Prechter, once a forecaster of great influence – George Soros once reported being “stunned” by Prechter’s decision to turn bearish prior to Black Monday in 1987, describing it as “the crack that started the avalanche”.

In fact, the most searched-for gurus on CXO’s site were typically only average to well-below-average in terms of accuracy. They are well-known due to “systematic” media exposure, not accuracy. Such gurus “may have motives other than accuracy in publishing forecasts”, CXO adds – they may simply be prone to “extreme forecasts to attract attention”.

School ties
It’s who you know, not what you know, that matters. According to one US study, analyst stock recommendations outperformed when the analyst went to the same university as a senior officer of the company being tracked. Investors could profit by creating a simple strategy of “going long on the buy recommendations of analysts with school ties and going short on the buy recommendations of analysts without ties”.

This pattern is even more obvious in the UK, the study found, diplomatically concluding that “school ties facilitate information-sharing”.

Ask the analysts
Earlier this year, US academics carried out a revealing survey of 365 market analysts. Less than a quarter said accurate and timely earnings forecasts helped determine pay packets. Just 35 per cent said making profitable stock recommendations was important in terms of pay.

One in six had been pressured by management to increase earnings forecasts; one in four had been pressured to lower forecasts (to allow the company beat estimates).

Almost 40 per cent believed issuing a downcast earnings forecast would result in losing access to management or being “frozen out” on conference calls.

And access remains crucial, despite regulations prohibiting the passing on of confidential company information. More than two-thirds said private phone calls with executives remained the most important part of their job. “It’s a way for them to broadcast,” one analyst said. “We’re sort of like a megaphone for them.”

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