Why Wall Street Analysts Get It Wrong So Often

I once asked the chief economist of a big-name investment bank why his peers always extrapolate current trends out to infinity to make their forecasts when the central belief of their discipline is that everything goes in cycles. He tried to mount a defense, but his heart wasn't in it. "Well," he said, mulling it over, "stock market analysts are worse."

His deflection was right on target. How often have you seen an analyst recommend a stock trading near a multi-year high, then stick with the call as the price descends to a bare fraction of that level before he finally downgrades it?

Here's an example from one blue chip that has fallen spectacularly from favor: General Electric. An analyst at a large European bank rated GE a buy in the summer of 2007 as it lingered in the high $30s. He finally cut the stock to neutral last fall after it had lost half its value, then reduced it to "short-term sell" in January with the share price hovering above $10.

Ostriches and Lemmings
Analysts often fail to anticipate changes in earnings and the factors that drive them, like evolving consumer habits, new-product cycles, or the rise or fall of a competitor. They often appear blind to developments long after they occur and after they are reflected in share prices. Like ostriches, analysts seem to put their heads in the sand.

Bizarre and unhelpful ratings, especially the lopsided number of "buys," often result from how analysts feel as much as what they think. They often face more pressure than economists or market strategists because analysts have close relationships to the companies they follow, and they are seen as having a direct influence on share prices.

The basic human desire to be liked compels analysts, perhaps subconsciously, to ensconce themselves within the consensus and not rock the boat.

"There's a tendency to be a little more timid about bad news," Tobias Levkovich, chief U.S. equity strategist for Citigroup, told me recently. "If you stick your neck out and break bad news, you get a backlash from owners of the stock."

That is true even when analysts get it right. The opprobrium is worse when their judgment is wrong, so why risk it? There's little or no penalty for making a mistake if your peers do too. Levkovich calls this "the lemming factor."

As sentiment toward a stock becomes extreme, either to buy or sell, the likelihood of a turnaround mounts. That's because the validation that the trend provides to believers grows. So the longer it's in force, the tougher it becomes for analysts to leave the group behind, change their opinion and avoid heading over the cliff.

Getting the Ax
Investment advisors may travel in packs, but packs have leaders. A stock often has one analyst, known as an "ax" in Wall Street jargon, who has a reputation for being early and correctly into or out of a stock.

You can identify such analysts by the high ratings they garner in peer surveys published by financial news organizations. They also feature prominently in compilations of stock rating changes available on market websites.

Axes may have better access to information than others who follow a stock, or maybe they earn their reputations by expressing idiosyncratic opinions more freely. Either way, with their disdain for "I'll-have-what-he's-having" sameness, axes can spot emerging trends or even set them, providing a rare commodity in the markets: fresh ideas not widely available elsewhere.

"There's lots of noise on Wall Street," Levkovich said. "One of the signals investors should pay attention to is when the ax on a stock is making a meaningful change. If you find analysts willing to put buys on stocks when others aren't, it's meaningful."