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November 20, 2011

Ban The Analysts? The Systemic Pressure To Be Positive

By Charles Rotblut

‘Ban the analysts!’
This is what European Union commissioner Michel Barnier recently suggested. Barnier proposed banning credit agencies from rating the sovereign debt of countries undergoing bailouts. The commissioner was pressured into withdrawing his proposal for a ban, though he is still pushing for other reforms.

Barnier’s suggestion was nothing new. Analysts, covering both credit and equity securities, have long been under pressure to be positive. At a time when confidence in certain European countries to repay their debts is faltering, it is understandable that the credit agencies would be a target of backlash. Barnier had hoped that by banning rating agencies he could restore faith in problematic European countries.

The problem is not so much with Barnier’s suggestion as with the systemic pressure that analysts are under. Banking analyst Mike Mayo openly discussed how his negative comments on financial companies have caused problems throughout his career in his book “Exile on Wall Street” (John Wiley & Sons, 2011). Government officials and regulators are often quick to attack analysts who lower their credit ratings; corporate executives tend to be more subtle, but they still can and do retaliate. An analyst can see his access to executives limited and encounter other forms of pressure. The fact that the number of “buy” ratings far exceeds the number of “sell” ratings is no accident.

Analysts are not completely innocent, either. They are subject to the same behavioral errors that the rest of us are. Analysts get close to the government entities and companies under their coverage, making analysts more sympathetic to the securities they are covering. (Not to mention making it easier to miss the forest for all the trees.) Analysts also succumb to herd behavior, meaning they are unlikely to create a forecast or reach a conclusion that is significantly different from that of their peers.

This is not to say that analyst research is universally bad. Quite the contrary, I think it has value when used properly.

What should you specifically look for? First, determine the direction of the change in rating and tone of the commentary. Are the majority of analysts more optimistic or pessimistic than they have been previously? (It is easier to find the rating than the actual commentary.) Second, for stocks, pay attention to the change in earning estimates. Though stock analysts are usually wrong when forecasting actual profits, they tend to be fairly good about predicting whether earnings will be better or worse than previously thought. (Plus, earnings estimates are easy to find.) Finally, if you can access a research report, read it to see if the analyst points out something you missed in your analysis. You don’t have to agree with the analyst’s conclusion, but you should understand why your opinion differs. (Many brokerage websites make research reports available to their clients.)

The Week Ahead

The U.S. financial markets will be closed on Thursday in observance of Thanksgiving Day. The U.S. equity markets will close early on Friday, at 1:00 p.m. ET.

Dow component Hewlett-Packard (HPQ) will report earnings on Monday. Joining the company will be nine other S&P 500 members including Tyson Foods (TSN) on Monday, Campbell Soup (CPB) and Hormel Foods (HRL) on Tuesday, and Deere & Company (DE) on Wednesday.

The week’s first economic report will be October existing home sales on Monday. Tuesday will feature the first revision to third-quarter GDP estimates. October durable goods orders, October personal income and spending, the final November University of Michigan consumer confidence survey and the minutes from November Federal Open Market Committee will be published on Wednesday.

Atlanta Federal Reserve Bank President Dennis Lockhart will speak publicly on Monday.

AAII Sentiment Survey

Bullish sentiment, expectations that stock prices will rise over the next six months, declined 2.8 percentage points, to 41.9%. Nonetheless, this was the first time optimism has stayed above 40% for four consecutive weeks since February 2011. The historical average is 39%.

Neutral sentiment, expectations that stock prices will be essentially unchanged over the next six months, fell 3.7 percentage points to 27.0%. This is the 17th time in the past 18 weeks that neutral sentiment has been below its historical average of 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, rebounded by 6.5 percentage points to 31.0%. This was the first time in four weeks that pessimism has been above its historical average of 30%.

AAII members continue to be more upbeat about the six-month direction of stocks prices than they were in August and September. Optimism remains cautious, however, as evidenced by the bullish sentiment reading. The slow level of U.S. economic growth, Europe’s sovereign debt crisis, Washington politics and the market’s daily volatility are
combining to keep confidence at historically modest levels, and the nerves of some individual investors are frayed.

About The Author - Charles Rotblut, CFA is  the VP for American Association of Individual Investors AAII Journal Editor.  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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