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Wall Street Analysts: Wrong But Useful

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Not at all contrary to the generally held opinion, stock analysts are often wrong. Usually wrong, in fact. This is a decent thing to know, but not useful in and of itself. The big question is whether or not investors can use the consensus view of stock analysts to add any value to their investing process. To explore the idea, Breakout welcomed Barry Ritholtz, editor of The Big Picture and all around good egg.

Ritholtz culled the research on stock analysts from outside parties like McKinsey and Bianco Research and came to a few meaningful conclusions:

1. Analysts are almost always too optimistic. "Looking a year out, their earnings expectations are about twice the growth rate we've averaged," he says. So far pretty much in line with what we thought, but it gets better from here.

2. Analysts are "especially wrong at turning points as you head into a recession."

3. The "only time they weren't too bullish," Ritholtz notes, "was right in the middle of a recession."

Putting all these facts together suggests a bullish trade may be forming. Just in the past couple weeks we've seen earnings estimates and target prices for the S&P 500 fall dramatically. Barclays Capital, Ed Yardeni, and most recently Wells Fargo have all taken an axe to their numbers for next year and beyond. Don't expect that trend to reverse itself when the earnings parade starts in October.

The market is already well into a correction having fallen as much as 18% from the highs of early July. Now, if you're in the camp that we're in a garden-variety tepid recession or simply a period of flat growth, estimates finally coming down are a good thing. As a rule and according to Ritholtz's work, analysts are too optimistic at any point other than the middle of a recession. The trade isn't shorting their optimism, which is nearly constant. The trade is buying their pessimism, which is specific to the lows of a recession.

As Ritholtz notes, unless the economy is on the verge of earnings collapse along the lines of the +25% collapse of 2008, stocks are starting to look attractive as an investment if not perhaps a trade. "If there is a typical cyclical recession, we're getting close to a market bottom," he says.

Analysts aren't bad people or always wrong, but they are somewhat predictable. They are also, taken as a whole, getting much more negative than is the norm. We may have some more multiple compression (Wall Street speak for "dropping stocks"), but a run of the mill recession is being priced in. Fighting the tape is a horrible idea. Fighting the estimates, on the other hand, could be a decent trade.

Food for thought. Keep the conversation going by tell us what you think in the space below.

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