I’ve been mulling over an article by Martin Waller. Waller reports some research into equity analysts that shows that analysts’ confidence about the market, as tracked by the ratio between buy and sell recommendations, is a counter-indicator. He argues that analysts have no idea what they are talking about when analysts look up, the market goes down, and vice versa.
The study by DigitalLook (a financial website) found that City analysts’ market predictions were often wrong over three years. When analysts predicted market falls, the market would rise, and vice versa. While the research is somewhat complicated by analysts’ tendency to issue more “buy” recommendations than “sell” recommendations, DigitalLook tracked the ratio between these recommendations to gauge overall market sentiment. The findings suggest that analysts consistently mistimed their positive and negative market outlooks.
They concluded that highly paid financial analysts in London’s financial district regularly got their market predictions wrong, which might vindicate sceptical fund managers and investors who doubt analysts’ expertise.
This explanation is not as strong as it seems because it neglects several possible explanations, including causality. For example, if every analyst recommends your firm, then demand for your stock rises. Your firm’s cost of capital falls because people are happier to invest more in it, even if the underlying risk in the business changes. This then changes the rate of return you need to make on projects to justify starting them: since investment is cheaper, less promising projects get the go-ahead. As a result, the overall return on the business goes down as these lower-value projects come online.
However, the big issue is why companies cannot better communicate their performance to analysts, considering the substantial investments in investor- and analyst-relations programmes?
