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The Entire Stock Market Is Biased in Favor of Buy Ratings

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’ve never heard them tell consumers to “sell.” An article by Clifford S. Asness in the Financial Analyst Journal makes this comparison. He accurately states that, “A large part of Wall Street’s business is selling new and used stocks and bonds, which strangely they do make recommendations about.” Of course, the Street rarely espouses bearish views on the very products it wants to sell to clients.

Wall Street is totally oriented to a rising market and upward moving stock prices. The common terms used by the Street 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’s called a “correction.” Isn’t that absurd? “Volatility” is another term that often surfaces 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’s seen as “stabilizing,” a favorable description. But if stocks are soaring, the market is never portrayed as being unstable. The Street just keeps trying to sugarcoat or neutralize the situation when stocks are not climbing in price.

Institutional investors hold stocks, are long, and rarely sell short or bet on a decline. Most mutual funds and institutions are not allowed to short stocks. Analysts are incentivized to issue Buy opinions by the favorable feedback that flows from major institutional owners of the stocks and from corporate executives. Analysts are discouraged from negative views by the adverse reaction from these constituencies. Sell opinions, especially if in the minority, put us on an unpleasant hot seat.

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 compared to 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 six Sells. Systemic bias? I’d say there are vast brokerage investment banking opportunities with these major corporations, subtly swaying analyst opinions. The system is stacked against negative recommendations.

Analysts have an anthropomorphic tendency to fall in love with the companies and stocks that they are advocating. It’s like identifying with your captors. Human instinct. The bias is ineffaceable. Some of the insanity has been eliminated and subservience to investment banking is reduced. But don’t 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 bubble, Salomon Smith Barney had only one Underperform and no Sells among nearly 1200 stocks it was covering. According to Zacks Investment Research, of the 4,500 stocks it tracked in the fourth quarter of 2005, 42% were rated Buy or Strong Buy. Only 3% carried Sell or Strong Sell recommendations. A research report by a major Street firm in spring 2007 indicated its research department investment rating distribution was 45% Buys, 47% Neutrals, and 8% Sells.

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 analysts from brokerage firm investment banks. The record was about equal during bull markets when Buy ratings are prevalent. But independents stand out in bad markets when they promulgate more negative views. Brokerage firms are seemingly reticent 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, creating another positive bias. Studies prove that the analyst at the brokerage that leads an initial public offering of a company, provides noticeably more affirmative coverage than analysts at firms unaffiliated with the deal.

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