Do Analysts Help Make the Market More Efficient?

By Howard Simons  AUG 05, 2013 10:00 AM

A review of analysts as coincident indicators.

 


People in the financial services industry might think of themselves as Masters of the Universe, but the universe seldom returns the sentiment. Entire segments, such as credit rating services and sell-side research analysts, too often find themselves in that Rodney Dangerfield “No Respect” situation.

My rejoinder here is along the lines of “So what?” It is like Congress as a whole getting a single-digit approval rating: As long as 90%+ get reelected, they could care less, and as long as credit raters and analysts find their opinions in demand, they will continue to make a good living.

Tough Job

The job of an analyst has always been a difficult one. I used to pose the question to students of whether they could predict a stock’s price if I gave them perfect knowledge beforehand of the firm’s earnings and of interest rates. Their initial impulse was always “Yes,” until we started peeling back layers of the onion and decided that too many other variables -- such as the market itself, competing assets, and the multiples investors were willing to assign -- would be need to be known

It really does make you wonder why so many approach investing by first trying to take a top-down look at economic growth, then look at sector health and finally consider earnings; over the past four years, the macro variables have been tepid, and both revenue and earnings growth have been lackluster while the market itself has shot to a series of post-crisis highs. Restated, this approach produces some great negative indicators.

The Oil Service Case

Let’s take the Oil Service Sector Index (INDEXNASDAQ:OSX) as a case study of analyst value-added. This index includes Schlumberger (NYSE:SLB), Halliburton (NYSE:HAL), Baker Hughes (NYSE:BHI), and Transocean (NYSE:RIG) amongst other heavyweight firms. Like all firms whose businesses tends to be “lumpy” in the sense that they are affected by a few large contracts, their forward-looking price/earnings ratios tend to be volatile. Analysts have to be on top of each firm’s pipeline -- no pun intended -- and they also have to stay on top of a commodity-driven sector.

How have they done over the past six-and-a-half years? Either very well or miserably, depending on your standard of judgment. If we map the relative performance of the OSX against the S&P 1500 Supercomposite versus the relative forward-looking P/E of the OSX against the S&P 1500, we find that neither measure leads the other. Restated, if you know the OSX’s relative performance, which is something that you can pull off of a quote screen, you know how the analysts’ opinions have been changing and vice versa. While this may sound like a lame performance, it also can mean that the analysts’ judgments are being reflected almost instantaneously in prices in a paean to the much-maligned efficient market hypothesis.



The entirety of the sample above has been extracted in the post-Regulation Fair Disclosure world established in the aftermath of the dot-com implosion, when Sarbanes-Oxley and not Dodd-Frank was the law to make the world safe for investors once again. Regulation Fair Disclosure, better known as Reg FD, was designed to impede favored analysts from getting ahead of their peers; it instead has succeeded in making them coincident indicators.

Is this a national tragedy? Not really; if we go back to that efficient market hypothesis, your long-term investing goals are served far better by wide diversification and proper asset allocation than by issue selection. This is not as much fun as stock-picking or active trading and maybe not even as entertaining as darting in and out of the Market Vectors Oil Service ETF (NYSEARCA:OIH) in the present case. But if the oil services case noted here is indicative, the gains from trying to beat the market’s prices are going to be few and far between. Just as the late Rodney Dangerfield was considered a comedian’s comedian and had all the respect he could want, maybe it is time we give the analysts a little love for making the market so efficient.
No positions in stocks mentioned.

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