The Truth About Wall Street Analysts & Why You Need Independence
Submitted by Lance Roberts of Street Talk Live blog,
Turn on financial television or pick up a financially related magazine or newspaper and you will hear or read about what some stock analyst from some major Wall Street brokerage has to say about the markets or a particular company. For the average person, and for most financial advisors, this information is taken as "fact" and is used as basis for portfolio investment decisions. But why wouldn't you? After all Carl Gugasian of Dewey, Cheatham & Howe just rated Bianchi Corp. a "Strong Buy." That rating is surely something that you can "take to the bank", right?
For many years I have been counseling individuals to disregard mainstream analyst and Wall Street recommendations due to the inherent conflict of interest between the major brokerage firms and their "retail" clients. For individuals it is important to understand the relationship between your financial advisor, their firm and you. When you hire a realtor to sell your house there is a clear understanding that the realtor will sell your house for a commission. It is spelled out in advance in a contract and compensation is based on performance. However, when it comes to financial advisors at major Wall Street firms the relationship is not quite as clear.
Major brokerage firms are big business. Really big business. As such they are driven by the needs of increasing corporate profitability on an annual basis regardless of market conditions. This is where the conflict of interest arises. For example, look at the annual EPS of JP Morgan from 1999 to present. Despite two major bear markets, which led to investor losses of 50% each time, JP Morgan never had a year with negative earnings per share. How is that possible?
When it comes to Wall Street profitability the most lucrative transactions are not coming from servicing "Mom and Pop" retail clients trying to work their way towards retirement. Wall Street is not "invested" along with you but rather use you to make income. This is why "buy and hold" investment strategies are so widely promoted. As long as your dollars are invested the mutual funds and brokerage firms collect fees regardless of market conditions. While "buy and hold" strategies are certainly in their best interest - it is not necessarily yours. However, these fees are a byline to the really big money.
In reality, Wall Street is focused on the multi-million, and billion, dollar investment banking transactions, such as public offerings, mergers, acquisitions and bond offerings which generate hundreds of millions to billions of dollars in fees for Wall Street each year.
However, in order for a firm to "win" that business from its major clients the Wall Street firms must cater to those clients. In this regard, it is extremely difficult for the firm to gain investment banking business from a company that they have a "sell" rating on. This is why "hold" is so widely used rather than "sell" as it does not disparage the end client. To see how prevalent the use of the "hold" rating is I have compiled a chart of all the stocks that are ranked by major Wall Street firms and broken them down into the percentages that are ranked "Buy", "Hold" or "Sell." See the problem here.
It is not surprising that there is just 7% of all stocks with a "sell" or "strong sell" rating. It's just not good for business.
However, the conflict doesn't end just at Wall Street's pocketbook. Companies depend on their stock prices rising because it is a huge part of executive compensation packages. Corporations apply pressure on Wall Street firms, and their analysts, to ensure positive research reports on their companies with the threat that they will take their business to another "friendlier" firm. This is also why up to 40% of corporate earnings reports are "fudged" to produce better outcomes.
So, what about the retail investor? If Wall Street is more concerned about big business why do they need the retail investor at all? This is where the conflict of interest becomes more clear. Wall Street needs someone to sell their products to. When Wall Street wants to do a stock offering for a new company they have to sell that stock to someone in order to provide their client, a company, with the funds that they need. The Wall Street firm also makes a very nice commission from the transaction.
Generally, these publicly offered shares are sold to the firm's biggest clients such as hedge funds, mutual funds and other institutional clients. But where do those firms get their money? From you. Whether it is the money you invested in your mutual funds, 401k plan, pension fund or insurance annuity - at the bottom of the money grabbing frenzy is you. Much like a pyramid scheme - all the players above you are making their money...from you.
In a recently released study by Lawrence Brown, Andrew Call, Michael Clement and Nathan Sharp it is clear that Wall Street analysts are clearly not that interested in you. The study surveyed analysts from the major Wall Street firms to try and understand what went on behind closed doors when research reports were being put together. In an interview with the researchers John Reeves and Llan Moscovitz wrote:
"Countless studies have shown that the forecasts and stock recommendations of sell-side analysts are of questionable value to investors. As it turns out, Wall Street sell-side analysts aren't primarily interested in making accurate stock picks and earnings forecasts. Despite the attention lavished on their forecasts and recommendations, predictive accuracy just isn't their main job."
The chart below is from the survey conducted by the researchers which shows the main factors that play into analysts compensation. It is quite clear that what analysts are "paid" to do is quite different than what retail investors "think" they do.
"Sharp and Call told us that ordinary investors, who may be relying on analysts' stock recommendations to make decisions, need to know that accuracy in these areas is 'not a priority.' One analyst told the researchers:
'The part to me that's shocking about the industry is that I came into the industry thinking [success] would be based on how well my stock picks do. But a lot of it ends up being "What are your broker votes?"'
A 'broker vote' is an internal process whereby clients of the sell-side analysts' firms assess the value of their research and decide which firms' services they wish to buy. This process is crucial to analysts because good broker votes results in revenue for their firm. One analyst noted that broker votes 'directly impact my compensation and directly impact the compensation of my firm.'"
The question really becomes then "If the retail client is not the focus of the firm then who is?" The survey table below clearly answers that question.
Not surprisingly you are at the bottom of the list. The incestuous relationship between companies, institutional clients and Wall Street is the root cause of the ongoing problems within the financial system. It is a closed loop that is portrayed to be a fair and functional system; however, in reality it has become a "money grab" that has corrupted not only the system but the regulatory agencies that are supposed to oversee it.
The Rise Of Independence
In the past few years there is a change that is occurring which is the rise of independence. Independent, fee only, financial advisors, private investment analysts, research and ratings firms have begun to infiltrate the system. Over the last several years the independent RIA (registered investment advisor) channel is growing faster than overall industry as retail investors are "catching on" to Wall Street's game. The "Occupy Wall Street" movement, while very misguided in its approach, was the first to ring the bell of the wealth gap between "Wall Street" and Main Street.
As more and more "baby boomers" head into retirement the need for high quality, independent, registered investment advisors will continue to grow. The need for firms that do organic research, analysis and make investment decisions free from "conflict," and in the client's best interest, will continue to be in high demand in the years to come as more "boomers" leave the workforce. While the "Wall Street" game is not likely to change anytime soon; the trust of Wall Street is fading and fading fast. The rise of algorithmic, program and high frequency trading, scandals, insider trading and "crony capitalism" with Washington is causing "retail investors" to turn away to seek other alternatives.
Of course, two nasty bear markets certainly have not helped Wall Street. Over the last several years the number of investment advisors has been steadily falling as individuals have taken back control of their own money. While individuals believed that Wall Street was out to take care of them the real truth was markedly different. Wall Street got rich while they got poorer. Now, those same individuals are hiding in bonds to find some return along with safety. The chart below shows the cumulative increase in bond funds versus stock funds as individuals seek safety over return.
Today, probably more than ever, the tide is shifting for retail investors. Those that want to venture into the shark infested waters of Wall Street on their own can certainly find plenty of tools, data and research online. Wall Street has the clear advantage in this game with billions of dollars invested in programs that can manipulate prices, front run trades and move markets to their benefit.
However, an independent advisor can help level the playing field between Wall Street and you. Provided they have the right team, tools and data they can spend the time necessary to manage portfolios, monitor trends, adjust allocations and protect capital through risk management. That expertise, combined with advances in technology, now allows individuals the freedom not to be locked into finding an advisor that lives down the street but to find the best fit for their personal goals and objectives. Today, top quality advisors have clients worldwide and can manage portfolios, communicate and service those clients effectively through technology.
The rise of independence is a good thing. Hopefully, it will continue to take root and grow into a dominant force in the marketplace that can affect regulatory change in the future for a more fair, transparent and less conflicted financial market. In the meantime, it is crucially important to start asking the right questions to figure out who is on your side.
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