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April 25, 2016

Changes in Analysts’ Recommendations Won’t Help You

Before you give into any temptation to follow analysts’ recommendations, consider this conclusion from three researchers: “On average, analysts’ revisions are not highly correlated with subsequent long-run returns, indicating that analysts do not provide new information that is relevant for the long run for typical investors.” The finding is from an appropriately named paper published in the Journal of Financial Economics, “Can Analysts Pick Stocks for the Long Run?” (A draft version is available on the SSRN website.)
The study finds that there is no aggregate post-revision return drift (PRD). This is an academic way of saying that the impact of an upgrade (e.g., from a buy to a strong buy) or a downgrade (e.g., from a buy to a hold) is not measurable 20, 60 or 120 days later. Yes, there might be an immediate reaction the day change is made, but it isn’t lasting.
This lack of a PRD is a sign that analysts are not supplying new information about which stocks to pick or avoid. In other words, you cannot hope to profit by buying a stock that has been upgraded by analysts or avoid a loss by selling a stock that has been downgraded. An exception may exist with small, less frequently traded companies, but even then, the data is murky.
To every rule, there are exceptions. It’s a significant challenge to identify a stock that will rise solely because of an upgrade (or fall solely because of a downgrade). A far more likely occurrence is the stock moving in reaction to whatever prompted the change in the analyst’s opinion (e.g., an earnings-related announcement, a change in the stock’s valuation, etc.). In this case, the market is reacting to the same information the analyst is as opposed to the analyst uncovering something unknown to other market participants.
This isn’t to say analyst research is worthless. The actual analyst reports can be useful for gaining information about a company and for identifying flaws in your own analysis. The key is to read the actual report as opposed to paying attention to whether the stock is rated a buy or a hold. (Analysts continue to avoid using the “sell” word as much as possible.)
There is even greater value in the changes (revisions) to earnings estimates. Not in the change made by any single analyst, but in the change of the overall consensus estimate, which is the average of all published analyst estimates. Upward revisions lead to a positive drift, meaning higher long-term returns. Downward revisions lead to a negative drift, meaning lower long-term returns. You can see the effectiveness of earnings estimate revisions in the AAII Stock Screens: Estimate Revisions: Up 5% and Estimate Revisions: Top 30 Up have the best long-term returns of any of the more than 60 stock screens we track, as of the end of last month (March 2016). Near the bottom—ranking third and fourth worst—are our Estimate Revisions: Lowest 30 Down and Estimates Revisions: Down 5% screens.
The Week Ahead
Friday, April 29, is the deadline for filing and suspending Social Security benefits for the purpose of making your spouse eligible to take spousal benefits. You won’t be able to do so afterward. Information about the rule change can be found in the January AAII Journal.
Nearly 200 members of the S&P 500 will report earnings next week. Included in this large group are Dow Jones industrial average components: Apple (AAPL) on Monday; 3M (MMM), Du Pont (DD) and Procter & Gamble (PG) on Tuesday; Boeing Co. (BA) and United Technologies (UTX) on Wednesday; and Chevron (CVX) and Exxon Mobil Corp.(XOM) on Friday.
The Federal Open Market Committee will hold a two-day meeting starting on Tuesday. The meeting statement will be released Wednesday at 2:00 p.m. ET. The futures market is pricing in a 97.7% probability of the target rate being unchanged.
Elsewhere on the economic calendar, March new home sales will be released on Monday. Tuesday will feature March durable goods orders, the Conference Board’s April consumer confidence survey and the February Case-Shiller home price index. February international trade and March pending home sales will be released on Wednesday. Thursday will feature the first estimate of first-quarter GDP.  March personal income and spending, the April Chicago PMI and the University of Michigan’s final April consumer sentiment survey will be released on Friday.
It’s not often that a Federal Reserve official makes a public appearance the same week as a FOMC meeting (beyond Chair Janet Yellen’s quarterly press conferences), but Dallas president Rob Kaplan will speak on Friday.
The Treasury Department will auction $26 billion of two-year notes on Monday, $34 billion of five-year notes on Tuesday and both $15 billion of floating two-year notes and $28 billion of traditional seven-year notes on Thursday.
About The Author - Charles Rotblut, CFA is the VP and Editor for American Association of Individual Investors (AAII). Charles is also the author of Better Good than Lucky. (EconMatters author archive here)
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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