Monkey Business: Why Stock Analysts Get it Wrong

Last Updated Apr 14, 2010 1:04 PM EDT

Darts famously rival investment pros in predicting the stock market. But a new McKinsey study suggests that while equity analysts are frequently wrong, at least their wrongness has order.

Stock-pickers are furthest off the mark in predicting corporate performance during periods of economic weakness, the consulting firm found. And not by a little. They do better when growth is strong. According to McKinsey:

This pattern confirms our earlier findings that analysts typically lag behind events in revising their forecasts to reflect new economic conditions. When economic growth accelerates, the size of the forecast error declines; when economic growth slows, it increases.
For example, analysts did better from 2003-06, when the economy was frisky, and they've done worse ever since (click chart to expand). This also helps to explain why investors tend to oversell when the market is down and undersell when it's up.

Stock analysts are consistent in another way -- they're maddeningly bullish. Over the last 25 years, analysts on average have predicted earnings per share growth of 10-12 percent for S&P 500 companies. Actual equity growth during that span is six percent. That means analyst forecasts overshot the mark by nearly 100 percent. Writes McKinsey:

For executives, many of whom go to great lengths to satisfy Wall Street's expectations in their financial reporting and long-term strategic moves, this is a cautionary tale worth remembering.
Or forgetting.

To figure out why stock analysts are so frequently and predictably wrong, you have to turn to behavioral economists. Their work in recent decades shows that people forced to make complex, uncertain decisions often fall back on informal rules and personal biases. Comedy and tragedy ensue, and in roughly equal measure.

On Wall Street, that typically results in expecting short-term trends to continue longer than they actually do. It also leads folks to underestimate the chances of an earthquake flattening the markets. Such inclinations aren't limited to equity analysts, of course. The entire financial crisis, along with previous speculative spasms, owes in some way to these alternating currents of exuberance and despair.

Another well-known, somewhat malodorous factor affects stock analyst forecasts -- the herd. In a highly influential 1990 study, economists David Scharfstein and Jeremy Stein showed that investment managers often follow their peers in calling the market, even if they know the pack is stampeding off a cliff. Why? Paradoxically, it's safer.

As Stein told writer John Cassidy in the latter's excellent book:

"The underlying idea is that if you do something dumb, but everybody else is doing the same dumb thing at the same time, people won't think of you as stupid, and it won't be harmful to your reputation."
Cassidy also cites other research finding that young fund managers whose forecasts bucked industry consensus were more likely to get fired -- regardless of how those funds performed. Put another way, it's frequently better to be wrong in numbers than right all by your lonesome.

Hey, we're human, no matter what the color of our pin-stripes. Like the rest of us, stock analysts seek order in chaos. Good luck with that. As everyone knows, that can drive otherwise sane primates totally ape crazy.

Image from Photobucket.com; chart from McKinsey

  • Alain Sherter On Twitter»

    Alain Sherter covers business and economic affairs for CBSNews.com.