The one thing Wall Street does much better than the KGB

Andrew Gordon - Thu 18 Jan, 2007

How dumb would it be to make investments based solely on the sacred pronouncements coming out of Wall Street? .....The curse of any company is to have all of Wall Street on its side. You see, those high expectations are already built into the stock price...

How dumb would it be to make investments based solely
on the sacred pronouncements coming out of Wall Street?
 
You’d be better off listening to the KGB (now called
the Federal Security Service, or FSB). If you did,
you’d know that the CIA was involved in the
assassination of President Kennedy and that U.S. forces
used chemical and biological weapons in the Korean War.

These are just two of hundreds of successful
“disinformation” campaigns waged by the government of
the Soviet Union against the U.S. and its European allies.

But the information coming out of Wall Street makes the
KGB look like rank amateurs. Consider the following:

In a Bloomberg article, John Dorfman writes that over
the past nine years, the four companies with the most
“buy” recommendations from Wall Street analysts have
lost an average of 3.7 percent per year.

The four companies with the most “sell” recommendations
did slightly better, losing 0.2 percent per year. During this
period, the S&P 500 averaged a 7.4-percent gain per year.

Last year was more of the same. The four “loved”
companies gained an average of 2.4 percent against the
nearly 16 percent enjoyed by the S&P 500. The four
“unloved” stocks?  They went up an average of 21
percent last year.

In 2000, all 12 of the biggest firms on Wall Street
agreed that the U.S. market would rally the following
year. In 2001, the S&P 500 dropped 13 percent. The next
time all 12 were bullish about the year ahead? The end
of 2006.

A Merrill Lynch survey at the beginning of 2006 showed
that fund managers were betting heavily on tech, and
betting against telecoms, utilities, and real estate.
Telecom and utilities had pretty good years. And real
estate jumped 33 percent to lead all sectors. The tech
sector, however, dragged.

What is going on here? How can Wall Street be so wrong
so often?

I can only paraphrase Warren Buffett, chairman of
Berkshire Hathaway (BRK), "A herd of lemmings looks
like a pack of individualists compared with Wall Street
once it gets a concept in its teeth."

That’s as good a theory as any. But I have another
one. And it paraphrases a well-known saying: With
friends like the ones from Wall Street, who needs
enemies?

The curse of any company is to have all of Wall Street
on its side.  You see, those high expectations are
already built into the stock price. It’s a rare company
that can consistently exceed such high expectations
quarter after quarter. If it can – as Google (GOOG) has
mostly done – everybody wants to buy those shares,
which pushes prices up further and raises expectations
even more. That’s why when richly valued companies
fall, they fall hard.

My colleague Rick Pendergraft agrees with this theory,
although he puts it differently.  He points out that
when all recommendations are “buys” on a stock, there’s
no room for analyst upgrades, even if the company
continues to perform well. But if the company misses an
earnings guidance or something else goes wrong, some of
those “buys” can turn into downgrades that will drive
the share price down in a hurry.

Even when Wall Street strategists see the edge of the
cliff ahead, they may mutter “uh oh,” but they forge
right ahead anyway. David Kotok oversees an $850
million fund at Cumberland Advisors Inc. He’s noticed
how supremely optimistic everybody is about the market,
“I’m an old believer that when everyone believes
something is going to happen, the opposite
happens. That causes me concern, because I’m bullish
too.”

Warren Buffett describes this behaviour as well as
anyone, but explaining such “bull” headedness? I
believe Jay Edward Epstein, who wrote a book about the
KGB and its deceptive ways, has the best handle on it:
“the target of disinformation ... must be in a state of
mind to want deception."

Who wouldn’t love to see a bull grab the market by the
horns this year and raise it to new heights? We can
hope it happens, but count on it? Please don’t. In
fact, count on it not happening. That way, you’ll be
prepared for the worst.

One way to prepare is to invest in solid dividend-
paying companies. When things get dicey, that’s where
a major portion of investment money goes. But why wait
for things to get dicey? Do it now because tomorrow may
bring stormy weather, especially if Wall Street expects
it to be warm and sunny.

Good Investing,
Andrew Gordon
for The Daily Reckoning