In the decades between 1910 and 1950, Werner Heisenberg and Erwin Schrödinger made the world of physics a murky place when they helped to establish the foundations of quantum mechanics, a fundamental and now widely accepted branch of physics.
As in physics, the financial world has a gaggle of mini-Schrödingers in the form of analysts who are always peeking into the future. And, much like some early discoveries in physics had devastating consequences, such as the invention of the atomic bomb, analyst observations can also cause serious chain reactions in a stock. In this article we will look at how analyst observations affect stocks.
Schrödinger is perhaps the most famous feline murderer in history. The truth is, Schrödinger never actually killed a cat - he just imagined killing one. The thought experiment involved locking a cat in an iron container with a beaker of poison and a trigger (radioactive material) that had a 50% chance of going off. Until you peeked into the box, you had to consider the cat both alive and dead when you made your calculations. One of the implications was that the observer affected the experiment by being part of it.
When analysts make their market predictions yearly, monthly and even daily, they are putting a given security into position that is as perilous as that of Shrodinger's cat. Unlike the radioactive particles, analysts' forecasts vary, and there is margin of error in how close a stock comes to an analyst's predictions and/or by how much it exceeds them. In an ideal world, a stock that surpasses an analyst's prediction would be rewarded accordingly, whereas a stock that fell short would suffer in proportion to its failure. But this is not the case. The type of stock for which the earnings forecast is made heavily influences the effect of analysts' predictions.
Growth stocks are analysts' favorite target and the area where they do the most damage. In theory, a growth stock that meets its expectations or exceeds them should see positive results in the value of its stock. The reality is that growth stocks gain very little benefit by exceeding expectations because it is generally believed that they are supposed to. This starts a dangerous cycle as analysts continue to raise the bar according to these new expectations.
Worse yet, a growth stock that fails to meet earnings expectations isn't merely given a slap on the wrist as might be expected with falling a few percent short, but is instead summarily executed. This is largely due to the fact that growth stocks are trading at high multiples of earnings. Investors who buy these stocks believe that growth stocks will repay them by earning more and more in the future. Analysts then provide the measure by which investors check if their faith in a stock is justified, giving them the ability to shoot down a stock when it falls below the benchmark they've set.
In contrast, value stocks are often bulletproof when it comes to analysts' forecasts. They are helped a little when they exceed expectations, but falling short rarely has much effect. There are many reasons for this: they trade at low multiples of earnings, the majority of investors in value stocks tend to buy and hold rather than trade, investor expectations are lower for value stocks and are already reflected in the share prices, and so on. An investor in value stocks can do well by buying when the stock fails to meet earnings forecasts and selling when it exceeds them.
Who's at fault?
So whose fault is it when a stock, particularly a growth stock, is punished? The future is an unruly creature that tends to bucks more the tighter one tries to rein it in. By taking the current data that accountants provide and trying to weave it into some picture of the future, analysts are doing the company a disservice by pretending to remove uncertainty from the equation.
Growth stocks can become slaves to the overly optimistic predictions of analysts to the point where a good company, through the enthusiasm of investors spurred by analysts, watches its stock become disconnected from its current operations and linked to some future version of itself. Then the choice is whether to disappoint investors and cause a correction, or expand rapidly, and often recklessly, to realize the destiny that the analysts have mapped out, driving the bar up again.
The Bottom Line
Analysts' predictions exist because traders demand them. The actions traders take based on these predictions reinforce the utility of analysts. Although the actions of analysts have little impact on the investment strategies of value investors, they are essential for the more active investors. Analysts provide an opportunity for traders to profit from the uncertainty their predictions (and the traders' reactions to those predictions) help exacerbate. For the companies represented by the growth stocks that analysts watch, analysts are sometimes akin to gun-wielding bandits telling them to shut up and get inside the box.