Why Wall Street Stock Predictions Are Meant To Be Wrong

Wall Street has a long tradition of rating stocks.

Analysts from big investment banks keep an eye on certain stocks. And each quarter, they grade them by issuing one of three ratings—buy, sell, or hold—along with a 12-month price target.

These “grades” draw a lot of eyeballs in the media. CNBC basically feeds off the news of newly issued ratings. And you can come across tons of articles like this every day:

But here’s the thing. Investing based on these ratings is like asking a car salesman if you should buy a car. In fact, the nature of a Wall Street analyst’s job forces them to massage those ratings. And as insane as it sounds, analysts who get it wrong most often get the fattest checks.

Huh? I’ll explain that in a moment. But first, some context.

How Wall Street “graders” earn money

Before we begin, I have to make one important distinction because there are two opposite sides of Wall Street. There’s the buy side of Wall Street and there’s the sell side. The difference is pretty self-explanatory.

The buy side buys stuff. It’s big investors like pension funds, mutual funds, or hedge funds that invest on behalf of others. The sell side, well, sells stuff. It’s investment banks like JPMorgan or Goldman Sachs that sell shares and bonds on behalf of public companies.

So the ratings you see in the media most often come from the sell side of Wall Street. And there are two main ways that side makes money.

First, as I’ve just touched on, investment banks help public companies raise money in capital markets by selling their securities to institutional investors. For example, every company hires a sell-side bank to underwrite its IPO or issue a new batch of corporate bonds and sell it off to investors.

The second big source of money is trading. But unlike what some people fantasize about Wall Street banks, they don’t trade for profit. Instead, they act as market-neutral brokers of institutional investors.

In other words, they help big investors trade large orders that mainstream brokers can’t handle and act as a “private matchmaking service” (in financial lingo: over-the-counter market) for stuff that doesn’t trade on an exchange (e.g., bonds).

For example, how do you sell $10 million worth of AppleAAPL
bonds when there’s no NYSE for them? You call an investment banker who buys your bonds (and later flips them)—or hooks you up with investors who are in the market for $10 million of Apple bonds.

In return, investment banks earn a commission, just like your broker.

How these banks win trade flow to make money

Wall Street salesmen have a bit of reputation for lavish outings to lure the buy side to trade with them. But no fancy fundraising dinner or lift on a private jet can beat the dearest favor a Wall Street banker can make for their client.

It’s putting them in touch with the management of a public company.

Because the sell side of Wall Street works as a middleman between public companies and institutional investors, it’s rubbing elbows with top executives and portfolio managers. And as you can imagine, this unique position allows them to hook them up in closed-door meetings.

Obviously, laws forbid company insiders to disclose market-sensitive scoops. But there’s a lot of gray area here. There’s no law that says you can’t discuss “hypothetical” ideas. For example, Tesla’s biggest shareholders tossed around, and correctly suspected, the merger of Tesla and SolarSystem way in advance.

And investors excel at picking up tones, or soft information; that is, body language and other clues that help foresee important events that affect the stock price.

The result is corporate access has become a booming back channel through which select large investors get an informational edge. Even academic research has shown that investors who meet often with execs tend to outperform those who don’t.

As a thank you, the favored buy-side investors shower Wall Street banks with trades from which the banks make fat commissions. Win win.

Rating accuracy or job?

Now, you’d think that the compensation of a person who makes predictions would depend on the accuracy of those predictions. But for the reasons we’ve just discussed, that logic doesn’t apply on Wall Street.

In fact, there’s an estimation that about one third of an analyst’s compensation comes from scheduling private meetings with executives. In other words, the more meetings an analyst arranges, the more money she makes. (There are also bonuses for bringing investment banking clients.)

Which puts analysts in a weird position.

On one hand, their designation binds them to make good calls. On the other, a good part of an analyst’s pay check (and, I guess, the job) depends on sucking up to executives. That will obviously make him think twice before putting out bridge-burning “sell” ratings.

And this is not some far-left conspiracy.

For years, Wall Street has been warning about the pressure public companies put on them. Even chief analysts of top Wall Street banks explicitly admit that they gloss up ratings out of fear of losing corporate access:

“There’s a tendency to be a little more timid about bad news,” Tobias Levkovich, chief U.S. equity strategist for CitigroupC
, told CBS News a while ago. “If you stick your neck out and break bad news, you get a backlash from owners of the stock.”

In other words, there’s a massive, massive, conflict of interest, which looks like this:

That’s the reason only ~5% of all issued ratings are a “sell.” And the ratio of buy/sell/hold ratings barely budge—even in the most violent market crashes.

That’s the reason “buy” ratings on average underperform the market.

That’s the reason ratings have never anticipated a turnaround in the markets:

And, that’s the reason the most sought-after and best-compensated analysts are those who often get it “wrong.”

Individual investors get the most “massaged” sliver of Wall Street research

In all fairness, ratings are just the tip of the iceberg. No, scratch that. The tip of the tip of the iceberg.

Underneath, there are multi-hundred-page reports that break down stuff at the most granular level. There are financial models that span thousands of Excel rows. And there are data and analyses even most institutional investors can’t afford to pull together.

In other words, institutional investors very much rely on the sell-side research to make investment decisions. But ratings and price targets—the sliver of that research that makes it to the public—is the most massaged and useless part of it.

And institutional investors are well aware of that.

They know the ratings that are supposed to reflect analysts’ reports are compromised; that it’s a trade-off for a chance to meet with more executives. So, they simply buy the research, happily hook up with the management, and then discount “buy” ratings.