SECURITIES PRICE PATTERNS
V: THE EFFICACY OF ANALYSTS' RECOMMENDATIONS
5.1 Introduction
As seen in the prior chapter, numerous studies of investment anomaUes appear in the academic literature. One area of interest that is particularly germane to this book is that of analysts' recommendations, a topic addressed in multiple studies over the past decades. Among the questions asked are: (1) Are analysts correct in predicting winners and losers? (2) Can investors profit from analysts' recommendations? (3) How do prices adjust to recommendations? and (4) Are analysts honest in their recommendations?
Because analysts' recommendations are likely the most readily available public information accessible to both individual and professional portfolio managers, this chapter summarizes in varying degrees several representative works pertaining to the above questions. The sources of advice include. Value Line and Morningstar, professional research organizations such as Standard and Poor's, popular outlets such as Forbes and the Wall Street Journal, brokerage house research departments, and others. We now turn to several studies which investigate the efficacy of and impact of this type of information. ^^
5.2 "Can Stock Market Forecasters Forecast?"
The earliest study of which we are aware that pertains to the effectiveness of investment advice is "Can Stock Market
29 This overview of the Hterature is representative, but not exhaustive.
40 Chapter V
Forecasters Forecast?" by Alfred Cowles 3*^^, which appeared in 1933. The findings of this work are prescient of the efficient markets view of investment returns, which would become widely popular decades thereafter. The initial section of the work addresses the stock selection success of 20 fire insurance companies and 16 financial services. The second part deals with the stock market forecasting skills of 25 financial publications.
The first series of tests include the evaluation of 7,500 separate recommendations made by 16 leading financial services over the 4/4 years ending July, 1932. Step one is the recording of each stock recommendation for each week, and this is followed by the tabulation of all off-setting transactions. With this information, the gain or loss is calculated for each round trip transaction and compared to the gain or loss of the overall market for the same period. Funds are equally redistributed among all stocks at the beginning of every six-month period. Compounding the six-month records yields the percentage by which each service's recommendations exceeds or falls behind the overall market. It is seen that the average annual rate of retum is - 1.43% relative to the bogey.
In Cowles' investigation of the common stock investments of 20 leading fire insurance companies, the author explains that these companies have a lengthy history of investing compared to both financial services and to investment companies, which are of relatively recent origin. Because the insurance companies' average portfolio turnover is only about 5% a year, the analysis is confined to the actual purchases and sales during the examination period rather than to the entire stock portfolio. The methodology employed, however, is essentially the same as with the investments services. It is seen that the stocks selected for investment effectively underperform the stock market by approximately 1.20%
annually.
Analysts' Recommendations 41
In Cowles' second series of tests, he first considers the market forecasting record of William Peter Hamilton, who employed the Dow Theory for forecasting purposes. (For a discussion of Dow Theory, see Cowles, p. 315.) As editor of the Wall Street Journal, Hamilton wrote 255 editorials over 26 years, which presented stock market forecasts. Based on these editorials, Hamilton was a buyer of stocks, seller of stocks, and out of the market, 55%, 16%, and 29% of the time, respectively. For the period 1903 through
1929, Hamilton would have earned a return of 12% annually, compared to the overall market return of 15.5% annually, as a control.
In the final set of tests, more than 3,300 forecasts are compiled from 24 financial publications from January 1, 1928, to June 1, 1932. The question is asked, "In the light of what this particular bulletin says, would one be led to buy stocks with all the funds at his disposal, or place a portion only of his funds in stocks, or withdraw entirely from the market?" On the basis of this, the funds are allocated to the market in proportions ranging from zero to 100%.
Using an involved scoring system, the author reports that only one-third of the list of forecasts was successful. Thus, he concludes that the average forecast earned approximately 4% per annum below what would have been eamed randomly. After further discussion of the statistical interpretation of the results found, the author concludes the article with the following summary:
1. Sixteen financial services, in making some 7500 recommendations of individual common stocks for investment during the period from January 1, 1928, to July 1, 1932, compiled an average record that was worse than that of the average common stock by 1.43 per cent annually. Statistical tests of the best individual records failed to demonstrate that they exhibited skill, and
42 Chapter V
indicated that they more probably were the results of chance.
2. Twenty fire insurance companies in making a similar selection of securities during the years 1928 to 1931, inclusive, achieved an average record 1.20 per cent annually worse than that of the general run of stocks.
The best of these records, since it is not very much more impressive than the record of the most successful of the sixteen financial services, fails to exhibit definitely the existence of any skill in investment.
3. William Peter Hamilton, editor of the Wall Street Journal, publishing forecasts of the stock market based on the Dow Theory over a period of 26 years, from 1904 to 1929, inclusive, achieved a result better than what would ordinarily be regarded as a normal investment return, but poorer than the result of a continuous outright investment in representative common stocks for this period. On 90 occasions he announced changes in the outlook for the market. Forty-five of these predictions were successful, and 45 unsuccessful.
4. Twenty-four financial publications engaged in forecasting the stock market during the 4 1/2 years from January 1, 1928, to June 1, 1932, failed as a group by 4 per cent per annum to achieve a result as good as the average of all purely random performances. A review of the various statistical tests, applied to the records for this period, of these 24 forecasters, indicates that the most successful records are little, if any, better than what might be expected to result from pure chance. There is some evidence, on the other hand, to indicate that the
Analysts' Recommendations 43
least successful records are worse than what could reasonably be attributed to chance.^^
We have summarized Cowles' work in much greater detail than will be done with those works that follow. The reasons for this are: (1) As the first of this type of investigation, the article is truly path-breaking and comprehensive. (2) The breadth of the investigation involves stock investing by insurance companies and recommendations by financial services, as well as overall market forecasting; and (3) The sheer magnitude of this study, which was done manually, is unique. Next, we briefly address several of the more recent studies in this arena.