For all the hoopla that is routinely being made about analyst ratings, surprisingly few analyst upgrades or downgrades in my experience have the power to move a stock for longer than one day. This then begs the question whether it is at all worth following analyst ratings. The answer is that it depends.
A little context
Analyst upgrades/downgrades, particularly from a widely-followed analyst can move a stock, if only for a short period of time, and that makes it lucrative to be clued in on this information before it becomes available to the public.
In the old days, and likely in some cases still today (although clearly illegal), brokers gave their best clients so called courtesy calls, tipping them off that their analyst is about to upgrade or downgrade a stock. The client would then act on this by buying or selling the stock and as a result cash in when the news hit the next day and the stock moved. Of course the SEC eventually clamped down on this and forced the banks to put up a so called Chinese Walls that clearly separate the research department from the investment banking and sales areas. Every once in a while an analyst upgrade/downgrade will still get leaked and the stock moves ahead of the announcement, but for the most part analyst moves are hard to predict as far as the exact timing is concerned.
Analysts tend to move in herds
Few analysts want to chance being caught completely on the wrong side if a stock moves in the opposite direction of what their forecast called for because at least part of their compensation is based on the accuracy of their forecasts. One way to hedge their calls is by always having their forecasts be close to the consensus of the analyst community for any given stock. What does this mean for the investors and traders looking for guidance from analysts? Simply put it could be catastrophic to base ones investment decision solely on analyst ratings because often times analyst consensus is uber bullish or bearish on any given stock and giving little alternate view on what could be wrong with their analysis.
Take the example of Apple Inc. (AAPL). After the stock rose sharply in 2011 and 2012, by August of 2012 the stock rose to a pre-stock-split adjusted $700 (or $100 in current price terms) while both investment sentiment and analyst ratings were at bullish extremes and few views of ‘what could go wrong’ were to be found. At that time plenty of analysts were declaring twelve months price targets of well above the $800 and even above the $1000 area. Sure enough, over the ensuing eight months the stock proceeded to drop by 45% while many analysts defiantly and stubbornly remained with their bullish cases for a good part of the correction. In other words, investors that in August and early September of 2012 were lured in by the bullish consensus calls of analysts after an already steep inline in the stocks price over the previous couple of years would have rather quickly encountered some nasty losses.
By the spring and summer of 2013, after AAPL stock’s severe drop, analyst sentiment had shifted to a more bearish posture and investor sentiment all but declared Apple as a company off as a growth story. Of course that’s when the stock again resumed its ascent, leaving analysts once again behind and having to catch up.
Analyst rating biases
While plenty of regulatory rules are in place so that analyst are not influenced by a banking relationship of their employer, there remain instances where it pays for the astute investor to be skeptical of an analysts rating’s bias. A bank that is about to help a publicly listed company raise funds in the bond market is unlikely to allow the analyst covering this company to slap a weak rating on the stock regardless of how warranted the analyst might think this is. This at least ‘temporary rating bias’ that can exist thus makes it difficult for investors to get an honest opinion from an analyst at any given time.
Next, it’s also imperative to recognize that analysts at least in part are there in order to to please the crowd, i.e. the large institutional and hedge fund clients of a broker. If a bank’s largest hedge fund client, i.e. the one bringing in the most brokerage revenue, is bullish on one stock or sector, the analyst is at least indirectly interested in not going completely against this client’s views in his publications. It also pays to be particularly skeptical about analyst ratings on hot momentum-favorite stocks, among them in the consumer technology space. Crowd-favorite momentum stocks that also bring in lots of commissions to the broker have a tendency to be more bullishly rated than they should be.
This brings me back to the earlier point which is that while some contrarian analysts certainly do exist, by and large those are more difficult to find than your average ‘go with the flow’ analyst. Moving with the herd of investment sentiment on any given stock can make an analyst’s life easier than constantly fighting the flow. While being wrong on any call is not much fun, it is particularly painful when an analyst is bearish on a hot momentum and crowd-favorite stock that continues to rise. True, the analyst may just have been early with his cautiousness, but investor memories are short and it is thus unlikely such a call will be hailed as successful in retrospect.
Using analyst ratings for investment purposes
Given all of the reasons that I laid out above why it may pay to be skeptical of analyst ratings, what then is a better way to use them? The analysis of price (technical analysis) is often most successfully applied when focusing on the ‘rate of change’, and it’s the same for analyst ratings.
Going back to the example of Apple stock from above, the time to start selling shares of Apple based on analyst ratings was between August and October. That time-frame was when analyst consensus was very bullish but the rate of change of analysts taking a more cautious stands slowly began to accelerate. In other words, when everyone is bullish, consensus can’t get any better and the smarter analysts will begin to slowly back off the bullish views. By the time the stock had dropped 45% in the spring/summer of 2013, analyst ratings were again negative and the smarter analysts began to get more bullish again. Thus, the rate of change of bearish to bullish switches slowly increased. The number of analyst bullish and bearish views can be followed on many news services.
Using analyst ratings for trading purposes
For trading purposes it is crucial to know that few analyst ratings have the power to meaningfully move the market for more than one day. In fact, all else being equal many analyst upgrades/downgrades of a stock eventually get faded, i.e. the initial rally/sell-off gets reversed. Through that lens it pays to at least wait for a daily close to occur, i.e. to see whether an analyst rating change or comment can stick around for more than a day.
Many if not most analyst rating changes and comments take place around earnings season, before or after a company’s earnings announcement. Aware traders know this and pay particularly close attention to analyst comments around those times.
Also, not all analyst comments are created equal, which is to say that a mere reiteration on a bullish rating more often than not is not as powerful as a new upgrade/downgrade note.
Using analyst ratings and technical an analysis
Last but certainly not least, active investors or traders can use technical analysis in conjunction with a rate of change of analyst ratings. In other words, smart traders will use one to confirm the other. Let’s say that any given stock has been bumping into key area of support several times and begins to accelerate higher. If this latest bounce is also occurring with an acceleration of bearish to bullish switches by analysts, it is likely a good time to start considering hopping on board the stock for a move higher.
