When Wall Street Analysts (Seemingly) Get It Right
Their trade alerts outperform their usual buy/sell recommendations.
Four professors wondered, “Are Analyst Trade Ideas Valuable?” To their pleasure--because null results don’t attract readers--they found the answer to be “Yes.” Wall Street’s stock-trade suggestions have indeed been insightful. Overall, Wall Street’s buy announcements outperformed the norm, by a significant and meaningful amount, while its sell reports trailed by an even larger amount.
(The authors are Justin Birru, Sinan Gokkaya, and Rene Stulz of Ohio State University and Xi Liu of Miami University of Ohio. It’s an Ohio thing.)
Their cover page surprised me because the U.S. stock market is so efficient. Besides, Wall Street analysts have been around since forever. If their signals were truly valuable, investors would clamor for them, rather than collectively shrug. (There was a time when the proclamations of Wall Street’s star analysts sparked headlines, but those days have long since disappeared, along with these critters.)
However, the authors studied something different. By “trade ideas,” they meant not standard buy/sell recommendations, which have time horizons of at least six months, but instead short-term counsel. They provide two examples. In one, the analyst issued a 30-day “trading buy,” predicting that a stock would rise when management began returning capital to shareholders. The other instance was also for 30 days, as the analyst expected the stock to rebound from a battering.
"Trade Ideas" is the first paper to study such advice. That news also surprised me, but it turns out that such announcements are relatively uncommon. Wall Street issued only 111 trading buy/sell signals in 2000. By 2015, that number had grown to more than 600, but that remained fewer than for standard recommendations. Most analysts do not issue trading signals; the marketplace is niche.
The authors compiled all available trade ideas from 2000 through 2015, then compared those stocks’ future returns against what would be expected, given their characteristics. (The authors used a three-factor model that accounted for size, price, and momentum for one set of calculations and a seven-factor model (!) for another.) That the buys immediately gained 1 percentage point more than the model expected and the sells lost double that amount didn’t impress me much. Typically, noise rather than brilliance pushes around a stock’s daily price.
But the subsequent figures were more convincing. After the initial effect, the buy alerts added another 100 basis points of “abnormal return” over the following two months, and the sell alerts subtracted 200 basis points. The movement was ongoing, such that the second month continued the pattern. That strikes me as meaningful: Investment news may travel slowly, but it does not require 30 days.
The Fine Print
There are three possible interpretations of the findings of "Trade Ideas": 1) the results were accidental; 2) the results were real but no longer apply, as stock market conditions have since changed, or 3) the results were real, and they continue.
Effectively, the first two possibilities are the same. Draw conclusions from an academic paper, apply those lessons in the marketplace, and be disappointed. Welcome to the world of exchange-traded fund providers! As investors in strategic-beta ETFs have learned, many if not most investment findings are one-time events. They are discovered and published and then cease to apply.
This is not to cast aspersions on "Trade Ideas." Its methods appear to be thorough, and its results are statistically significant, usually at the 1% level. My skepticism is instead a required disclosure for investment research--and for this column’s arguments, which are no sounder than the investment research that it cites. Buyer beware.
That said, conclusions from "Trade Ideas" can be supported by a credible story: The analysts’ alerts exploit an underappreciated time horizon. Most investors, both professional and retail, buy stocks for the relatively long term. A portfolio turnover rate of 200%, meaning an average holding period of six months, is regarded as aggressive. On the other end of the spectrum are day traders. Everyday practitioners have largely disappeared since the Roaring '90s, but hedge fund activity has increased.
With so much money researching the same opportunities, using many of the same calculations, it’s no surprise that fundamental investors, who are the most numerous, face the fiercest competition. As is widely known, few mutual fund managers--who are almost entirely fundamental buyers--consistently outdo their benchmarks. Day-trading is also difficult, but some hedge funds do show persistence. Then, perhaps, comes high-frequency trading, which was once lucrative, but which became more competitive as new firms entered the business.
That covers the long/intermediate, daily, and infinitesimal time periods. What remains is short-term: more than a single day but less than several months. That time period appears to be less frequently served. In my day of interviewing mutual fund managers, I do not recall any who had three-month time horizons, aside from those who responded to quarterly earnings surprises, which are different events than those analyzed in "Trading Ideas."
As investment opportunities, these four time periods are only distantly related, if at all. Whether a stock attracts a high-frequency trader has little to do with its day-trading profitability, which is at best indirectly connected with its short-term merits, which diverge from its long-term value. In short (so to speak), each time period’s investors evaluate different evidence, for different purposes. What they learn does not cross their time period’s boundaries.
This argument is built upon the same assumptions that underlie "Trading Ideas" and thus should not be overstated. Much work must yet be done to validate the concept that altering the time horizon affects the chance of one’s investment success and that the best opportunities, arising from the orchards less visited, are found with short-term trades. But the notion is believable. It obeys a certain logic, and it aligns with observed stock market behavior.
As investment hypotheses go, one could do a lot worse.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.