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Wall Street Has a Congenitally Favorable Bias

Think of Wall Street as if it were the auto industry. Automobile companies make cars and trucks. Through their dealers, they sell these products aggressively. Given their vested interest, auto dealers recommend “buy.” You have never heard them tell consumers to “sell.” An article by Clifford S. Asness in the Financial Analyst Journal makes a similar comparison. He accurately states, “A large part of Wall Street’s business is selling new and used stocks and bonds, which strangely they do make recommendations about.”

The Street rarely espouses bearish views on the very products it wants to sell to clients. No matter how deep the bear market or how clouded the outlook, brokerage firms want investors to continue investing in stocks. A leading firm emphasized in its February 2009 magazine to investor clients, “Defensive investing does not mean staying out of the markets. Look for conservative opportunities.” John C. Bogle, founder of the Vanguard mutual funds, claims: “Our financial system is driven by a giant marketing machine in which the interests of sellers [Wall Street] directly conflict with interest of buyers [investors].” Fifty percent of all trades are sales, by definition. Yet more than 90% of all research is directed at buyers, positive Buy recommendations, or Holds.

The press also leans heavily to the optimistic side. Entering 2008, amid the worst bear market since 1931, the leading financial magazines featured cover stories such as “Your Comeback Year—2009,” “Get Your Money Back—A Six-Step Plan to Rebuild Your Savings,” and “Yes, Things Are Grim, But Here’s Your New Plan to Emerge Stronger.” Even the venerable Barron’s, in advertising the debut of its new newsletter, emphasized that it would present an “investment idea each day...90% of the calls will be bullish.” Wow, 225 Buy recommendations a year—one every business day! And almost all Buys, even in a bear market. That same publication features an annual market forecast by 12 leading Street investment strategists. At the outset of 2008, the panelists’ S&P 500 predictions for the year ranged from 1525 to 1750. The end result was an astonishing miss from the actual 903 at year’s end. The dozen 2009 forecasts for the S&P 500 were again universally bullish, from 950 up to 1250, despite the bear market scenario.

Wall Street is totally oriented to a rising market and upward-moving stock prices. The common terms used to describe stock market conditions are heavily slanted toward the positive. When the stock market drops and you lose money in your stock holdings, it is called a “correction.” When the market rises, the Street does not call it a “mistake.” “Volatility” and “turbulence” are other terms that often surface to describe a falling market. Isn’t a surging market just as volatile as a declining one? A plummeting market finally bottoms out, and it is seen as “stabilizing,” a favorable description. But if stocks are soaring, the market is never portrayed as being unstable. When the economy dips into recession or the employment level falls off, it is termed “negative growth.” The government is the same way. When Ben Bernanke testified before Congress, he refused to use the R-word (recession), instead referring to a “contraction” of the economy.

The Street just keeps trying to sugarcoat or neutralize the situation even when stocks are diving, as during the 2008 bear market. As Barron’s described, its attitude is like the federal government’s: “Fundamentally everything’s fine...not to worry, it’ll soon get better.” Or “Wall Street...enjoys singing in the rain without an umbrella, hoping to lift investors’ spirits—and, just coincidentally, brokerage commissions and positions—by pretending to espy nonexistent rainbows, accompanied, of course, by their obligatory pot of gold.”

Most institutional investors hold stocks, long positions, and rarely sell short or bet on a decline. Analysts are given incentive to issue Buy opinions by the favorable feedback that flows from major institutional owners of the stocks and from corporate executives. They are discouraged from expressing negative views by the adverse reaction and often disparaging remarks that follow from these constituencies. In fact, when organizations are holding several million shares of a stock, you can imagine their reaction to a Street downgrade that drives the price several points lower. These organizations have portfolio managers who make stock selections; they do not need Wall Street analysts for that purpose.

A Wall Street Journal study in early 2004 found the positive bias to be most glaring at smaller brokerage firms that still seem to be in the rut of hyping a lot of Buy recommendations. Even the ten major firms that agreed to several research reforms in a 2003 industry settlement with the New York Attorney General averaged about twice as many Buy ratings as Sells. The ratio was almost seven times more Buys at smaller firms. In a mid-2006 CFA magazine article by Mike Mayo, it was noted that of the recommendations on the ten biggest market cap stocks in the U.S., there were 193 Buys and only 6 Sells. Systemic bias? Analysts’ opinions are swayed by vast brokerage investment banking opportunities with these major corporations. The system is stacked against negative recommendations.

Analysts have a tendency to fall in love with the companies and stocks that they are advocating. It is like identifying with your captors. Human instinct. Their bias is ineffaceable. Some of this insanity was eliminated when subservience to investment banking was reduced. But do not think for a second that full objectivity has been restored. The percentage of favorable Street recommendations still far outweighs negative opinions, at least if you take published ratings literally. In early 2001, ten months into the precipitous market slide that followed the Internet bubble, Salomon Smith Barney had only one Underperform and no Sells among the nearly 1,200 stocks it was covering. According to Zacks Investment Research, of the 4,500 stocks it tracked in the fourth quarter of 2005, amid the ongoing bull market, 42% were rated Buy or Strong Buy. Only 3% carried Sell or Strong Sell recommendations.

At the end of 2007, after a notable stock market drop, the distribution of Wall Street research opinions was 49% Buys, 46% Neutrals, and only 5% Sells. During 2008, the number of hedged, unhelpful Neutral or Hold Street opinions skyrocketed as stock prices nose-dived, but Sells remained scarce. By the end of January 2009, some 16 months into the bear market, according to Bloomberg data, there were still less than 6% Sell recommendations on the Street, compared to 58% Neutrals and 36% Buys. In randomly glancing at a February 2009 research report on a healthcare company, I noticed the analyst carried 17 Buy ratings on the 28 companies covered, more than 60% favorable views despite a bear market. This is typical. The major brokerage firm that altered its opinion rating system in 2008 required its analysts to rank at least 20% of the stocks under coverage as Underperform (Sell). That led to 31% of all the stocks covered by the firm being rated as Sell, an admirable balance compared to the rest of Wall Street; but it still left 69% of the coverage universe with ratings of Buy or Neutral during perhaps the worst bear market since the Great Depression.

A study by UCLA, UC Davis, and the University of Michigan reveals another form of skewed recommendations. Independent stock research opinions are more accurate than those of analysts from brokerage firm investment banks. The record is about equal during bull markets when Buy ratings are prevalent. But independents stand out in bear markets such as 2008, when they promulgate more negative views. Brokerage firms are reluctant to downgrade investment banking clients. Gee, why am I not surprised? A brokerage analyst invariably maintains a closer relationship and has more access to executives of an ongoing banking client. Studies prove that the analyst at the brokerage that leads a company’s initial public offering provides noticeably more affirmative coverage than analysts at firms unaffiliated with the deal.

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