During the Wall Street research scandals a few years ago, the paucity of "sell" ratings was cited as prima facie evidence of corruption. In early 2000, the vast majority of stocks covered by brokerage firms were rated "buy" and less than 1 percent were rated "sell." After the crash, there seemed only one explanation for the disparity: Wall Street analysts were fraudulent shills, gleefully touting the lousy stocks of investment-banking clients.
So regulators restructured the industry, skewered alleged miscreants (yours truly), and steered hundreds of millions of dollars to independent research firms, where analysts were free from investment-banking conflicts. And two years after the delousing, are half of stocks rated "sell"?
American Technology Research, one of the new breed of independents—a firm "dedicated to delivering quality, unbiased, fundamental research"—recently rated a whopping 4 percent of stocks it covers "sell." On the brokerage side, Merrill Lynch rated 6 percent "sell" (including, notably, 17 percent of banking clients). In other words, despite the $1.4 billion settlement, new rules, a barrage of lawsuits, and the creation of independent firms, the percentage of sell ratings has hardly budged. We can draw one of two conclusions: 1) Even after the reforms, Wall Street analysts are frauds; or 2) The paucity of "sell" ratings wasn't (and isn't) the result of a conflict of interest between banking and research.
The banking-conflict explanation for the rating disparity has by now been repeated so often that most people regard it as fact: Analysts, hungry for underwriting fees, guaranteed "buy" ratings to butter up banking clients. But as the continuing lack of "sells" suggests, the explanation is far more complex.
To begin with, there is selection bias. Wall Street analysts don't usually cover all the stocks in an industry, or even the majority. Covering a stock costs time and money. Most investors are "long only," meaning that they just own stocks, they don't sell them short (a way of betting the price will drop). Consequently, most investors don't want or need to hear about dogs. Back in the bubble days, for example, the average Internet analyst covered less than 10 percent of the more than 400 Internet stocks in the market. Had each analyst also rated the other 90 percent, there would have been more "sells."
Second, as I've discussed, ratings aren't action recommendations; they are judgments about how a stock might perform over a defined time frame. In some cases, this performance is relative (better or worse than the S&P 500, for example); in others, it is absolute (will the stock go up or down). In a bull market, the rising tide lifts most boats, and analysts who make judgments about absolute performance must take this into account. In a bear market, meanwhile, when most stocks are dropping, long-only investors still have to own something—a mutual fund can't just park its assets in cash. In this case, analysts don't help fund managers by opining that every stock in the sector is going to drop; they help by identifying the stocks that will drop least. In relative rating systems, these stocks deserve "buy" ratings even though they are going down.
Third, analysts are subject to the usual human psychological tendencies, such as herding: It feels safe and comfortable (and right!) to be part of a crowd. When the majority of analysts are wildly enthusiastic, a pessimist may worry that he or she is missing something or that a low rating will be seen as overly negative (akin to a "C" grade at a college where the average grade is "A-minus"). A recent study, in fact, found that "peer effects" were the most important factor in shaping analyst ratings on Nasdaq stocks from 1998-2003. (The same study found that the impact of the banking conflict was not statistically significant.)
Fourth, when the crowd is optimistic, being pessimistic can be disproportionately risky to an analyst's livelihood. In the research reforms, regulators focused on one potential source of conflict—bankers—but ignored the other two. For most analysts, even back in the bubble days, the loudest complaints and threats came not from bankers but from companies and investors.
The most valuable commodity on Wall Street is information, and no matter how many laws require companies to disseminate information to everyone, relationships still matter. A press release can't convey a CEO's facial expression when he or she is startled by a pointed question—and yet such expressions can transmit more information than a 100-page SEC filing. Smart investors and analysts cultivate relationships with company managers, and these relationships can evaporate in an instant when the analyst goes negative. The first time I downgraded a stock that other analysts loved, the company's management shut me out for three months. Although such blatant retribution is rarer now, companies still exact revenge. One of the most valuable services brokerage firms provide for big investors, for example, is arranging for company managers to visit their offices. Many companies refuse to go on the road with firms that are negative.
Investors, too, carry big sticks, and, like companies, don't hesitate to swing them. Major fund companies pay the Street hundreds of millions of dollars a year—way more than even the biggest banking clients. When a fund company owns, say, 5 percent of GE, and an influential brokerage-firm analyst trashes the stock, the fund managers don't usually call the firm and say, "Thanks for the tip." Instead, they usually say something like, "Your analyst is an idiot, and thanks to his big mouth, our funds will be down this morning." An analyst who routinely takes potshots at an institution's holdings won't be regarded as helpful for long, especially if he or she is wrong. (If the analyst is right, that's a different story, but the institutions have analysts, too, and if they thought the brokerage analyst was right, they wouldn't own the stock.)
These realities create what might be described as Pascal's Wager for Brokerage Analysts, a risk/reward equation that, when everyone else is positive, makes it risky to be negative:
- If the analyst is positive and right, he or she gets one point (it's good to be right, but others usually share the credit).
- If the analyst is positive and wrong, he or she loses one point (a black eye, but others share the pain and blame).
- If the analyst is negative and right, he or she gets three points (companies and investors scream, but everyone respects a good call, and sooner or later they'll come groveling back).
- If the analyst is negative and wrong, he or she loses ten points (companies, investors, and bankers scream, the stock rises, and, in addition to trashing relationships, the analyst becomes the village idiot).
There is a final reason for the current ratings disparity, one that requires some historical perspective. As Warren Buffett has observed, most investors make decisions based on the "rearview mirror": Specifically, they expect more in the future of what they have seen in the recent past. In 2000, when fewer than 1 percent of stocks were rated "sell," the market had been rising for 18 years. Analysts, investors, brokers, and commentators under 40 had experienced nothing but a bull market, and those over 40 could be forgiven for thinking that the nasty '70s were, thankfully, ancient history.
Long bull markets breed optimism: Investors are far more bullish at the end of them than at the beginning. The last few years have been painful, but the memories of 1982 to 1999 remain fresh, and most analysts and investors still expect a return to this happy trend. Unfortunately, as Buffett has also observed, the rearview mirror is not a crystal ball. In 10 years, if the market has remained stagnant, investors and analysts will gradually get more bearish, and the percentage of "sell" ratings should finally increase.