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Pigs on a farm. (iPhoto.com/iPhoto.com)
Pigs on a farm. (iPhoto.com/iPhoto.com)

Preet Banerjee

Herd analysts are putting lipstick on every pig Add to ...

The “lipstick on a pig” quote is pretty infamous after the 2008 U.S. presidential race and former Merrill Lynch analyst Henry Blodget's enthusiastic recommendations on stocks that he privately derided. It looks like there is still lots of lipstick on Wall Street.

Earlier this year, a report from Standard and Poor’s indicated that of the 1,485 stocks making up the S&P 1500 index, not a single one had a consensus sell recommendation from Wall Street analysts. That doesn’t mean there wasn’t the odd sell recommendation, it just means that there were no stocks that most analysts agreed had less than rosy prospects. Meanwhile, the S&P 1500 is down 2.77 per cent including dividends to Oct. 19, with the financials sector down 19.97 per cent.

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In a recent neuroeconomics and behavioural finance presentation by Barry Ritholtz, chief executive officer of Fusion IQ in New York, who also writes The Big Picture blog, he also noted that only 5 per cent of all Wall Street recommendations were sell recommendations in May, 2008, according to data from Bloomberg. The markets didn’t reach their troughs until March, 2009. During the tech run up in the late 1990’s, this figure was only about 2 per cent.

This can partly be explained by what Mr. Ritholtz referred to as “herding.” A similar concept is the “institutional imperative” which Warren Buffett identifies as a red flag in companies he is looking to invest in. Simply put, it’s the tendency for people to act the same no matter how irrational it may appear.

Why would they do that?

If you make the same recommendations as everyone else, then you don’t stand out if the stock goes up or down. If you go against the crowd and you’re right and everyone else is wrong, you look like superstar. But if you’re wrong and everyone else is right, you have a greater chance of being shown the door. Average or average? Superstar or fired? Most people will pick the former.

The fact that the herd has an upward bias is not news. Financial institutions advising companies on going public and raising new capital on one side of the building and making recommendations to investors to buy the same companies on the other side of the building is a conflict of interest that’s been scrutinized before. But if we were only running at 5-per-cent sell recommendations in 2008, you know questions are being asked.

But it is worth mentioning a paper titled “Analyzing the Analysts: When Do Recommendations Add Value?” (Jegadeesh, Narasimhan, Kim, Joonghyuk, Krische, Susan D. and Lee, Charles M.C., May 16, 2002). In it, the authors find a strong correlation between changes in recommendations and short-term stock price changes. However, they do propose an alternate hypothesis that the changes in ratings are in fact the cause of short-term price movements subsequently as traders act on that new information.

Now if stock markets over long periods of time provide a positive return, which they have, then you have to consider that perhaps the market is being the irrational one right now and investors are exhibiting a herding mentality out of stocks. Long-term investors, with a proper allocation between equities and fixed income for their risk tolerance can ignore the short-term noise from analysts and the markets.

Bulls, bears and pigs with lipstick: it’s a jungle out there.

Preet Banerjee, BSc, FMA, DMS, FCSI is a W Network Money Expert, and blogs at wheredoesallmymoneygo.com . You can also follow him on twitter at @PreetBanerjee

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