sell side over-optimism explained as the trend fades

As though we needed another reminder, the early-year plethora of “second half recovery” economic and corporate earnings forecasts highlighted the consistent over-abundance of optimism  among sell side analysts. In order to understand this phenomenon it is important first to throw out any assumptions you have about investing and then fully comprehend that the goal of every capital markets participant is not to correctly predict the course of markets  – it is to generate commission today. The entire structure of the industry, from the personality types favored by HR to the compensation structure to the seating arrangements are all designed to facilitate this.

Consider the daily routine of, say, a typical institutional equity salesperson. They are generally at their desks reading news feeds and research published overnight by 7:00am. The research meeting starts at 7:30 and the analysts present any changes to the earnings forecasts of their companies and the economists and strategists may outline their predictions. At 8:00 they return to their desks and at this point the truly rich separate themselves from the merely wealthy. Between 8:00 and 9:30 the salesperson calls their best clients (ie the most aggressive traders) – mutual fund, hedge fund and pension fund managers – and attempt to leverage any information they’ve learned since 7:00 to get these clients to make trades. Their careers are dependent on these calls – it is, in other words, their entire job.

You may have been under the assumption that analysts, economist and strategists are compensated to the extent they are correct in their forecasts. This is only true to the extent that accurate predictions generate trade commission. In the end, analysts, strategists and economists are paid directly in accordance to how much trading commission can be generated from their reports. Importantly,  bearish news is not conducive to trade generation. Even in the rare instance where bearish news does instigate sell ticket commission, unlike buys a sell does not imply repeat business. Stocks that are bought need to be sold, with commission on both sides. The cash realized by sells may never return to the trade desk again.

It follows then that the career risks in being bearish and wrong far outweigh the benefits of being bearish and correct. The experience of Quant Strategist Richard Bernstein while at Merrill Lynch in the 1990s is instructive here, illustrating the importance of timing. (For the record, Bernstein is my pick as the best strategist alive, but thats a story for another day). In 1997, Bernstein stridently made the case that technology stocks were drastically overvalued, in a bubble, and poised to fall more than 50%. The trading floor and investment banking departments were understandably displeased that their strategist dared to step in front of the money train, and struggled to explain away the conclusions while the steady conveyor belt of .com new issues (the true high margin cash cow of the industry) remained 400% oversubscribed.

By mid 1999 there were rumors that Merrill would replace Bernstein with a more malleable Abby Joseph Cohen “buy at any price” clone. Ms Cohen had assisted Goldman in generating steadily higher market share in tech stock trading and underwriting with a relentlessly bullish, “tree will grow to the sky” outlook for the industry. This outlook, supported by 60-slide presentations outlining future growth, helped portfolio managers assuage their anxiety over insane valuation levels and allocate more of the oceans of client funds coming through the door into the most overpriced market darlings of the day – Cisco, Intel, Oracle, Amazon, Yahoo!, Microsoft and the whole host of hot money hangers on. The 8:00 calls from Goldman institutional sales people were much easier and more profitable to make than for their counterparts at Merrill (although admittedly Blodgett helped offset the difficulties). Ms Cohen was made partner just as the implosion began, again, not because of prescience but because of successful, commission-generating cheerleading.

Vindicated but still unpopular, Bernstein hung on long enough to re-make his career both by successfully predicting the extent of the dot.com carnage and, more importantly, making one of the greatest calls in investing history with “Investment Bankers: Leave Silicon valley and head to Texas” in early 2000, successfully predicting the rise of the energy sector. Nonetheless, his experience is instructive – to be bearish on Wall Street you not only have to be right, you have to be right at exactly the correct time or face the risk of losing your job. Abby Joseph Cohen on the other hand, shows that being bullish and wrong is much less of a problem; the company makes money, you get made partner, and then you shrug your shoulders and say “no one could have predicted…” even though others did.

There are reasons to believe that this structural bias towards sell side optimism may be coming to an end. Demographic factors and the 20-year rally in bonds, the latter having successfully shoveled trillions of dollars into the equity market, are not only declining in terms of their positive effects but actually reversing into negative forces. Even discounting the risks of regulation and protestor pitchforks, the size of the financial services industry is likely to decline along with average market performance. If this comes to pass, the more bearish of forecasters may begin to gain respect. We can only hope.

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43 thoughts on “sell side over-optimism explained as the trend fades

  1. [...] sell side over-optimism explained as the trend fades (Interloper) [...]

  2. GYSC says:

    Thank you, plenty of elements to this post.

  3. ‘one of the greatest calls in investing history with “Investment Bankers: Leave Silicon valley and head to Texas” in early 2000, successfully predicting the rise of the energy sector.’

    In 2008, did he say, “Leave Texas and head to Michigan and Illinois?” ;-)

    • Interloper says:

      He was on his own by then and I can no longer see his reports. I know he did call for SPX outperformance of emerging markets at the beginning of 2011, though. First to warn of inverted yield curves in BRIC also. Thanks for commenting.

  4. Will in Seattle says:

    Thank you for saying what needs to be said!

    • Interloper says:

      To be honest, I’m surprised at the reaction. Traders and salespeople are bottom-line focused like anyone else in other industries. I’m not sure why people outside the industry think its different in finance than pharma sales or something. Thanks for e comment.

  5. samsoro says:

    interesting, I read this post thinking asymmetric comp based on fed put — upside gains, truncated losses on fed easing & bailouts. This view adds fuel to that same fire. The industry has benefited from expanding its balance sheet (and off balance sheet) for years collecting fees. But economic growth wasn’t fast enough to grow fees so leverage on the personal balance sheet did the job. It’s like boiling the frog unaware of the slow growing lethal heat…very hard to see catastrophe in slow motion.

    • Interloper says:

      True, and I want to cover that at some point if I think I can add anything. My basic point in this post, though was that nothing beyond the next eight hours matters much to what happens in capital markets. As long as the music’s playing…..

      • samsoro says:

        We are all incentivized automotrons, slogging it out …why should we question it when it seems to work for so many years? One imagines the incentive structure (equally compensating success and penalizing failure) should ultimately properly deploy capital and bring us to a mutually beneficial end. It’s the asymmetry that seems to have killed us IMO. There was a post on this very point which I can’t find at the moment, but I will forward if I can find it. Have a good one and thanks for the post.

  6. samsoro says:

    here is the link on the “asymmetric comp” concept…goes much further a la OWS etc., spooky http://www.zerohedge.com/news/nassim-taleb-occupywallstreet-and-his-updated-views-global-banking-system

    • Interloper says:

      Trust me on this – EVERYONE in the industry has either seen or heard a summary of that Blooberg vid by now.

      • samsoro says:

        ah, so where does the industry consensus lie on the spectrum? (“lunatic” — 1 vs. “dead on” — 10). I’m sure there are many shades of anecdotal differences. Again, thanks for your post…and awesome chat

  7. kid dynamite says:

    It always comes back to confirmation bias – the money management is de facto net long, and wants their hand held, wants to be told that everything is allright. Or, in this case, as you put it; “helped portfolio managers assuage their anxiety over insane valuation levels and allocate more of the oceans of client funds coming through the door into the most overpriced market darlings of the day “

    • Interloper says:

      Exactly, but the problem with not doing this goes back the issue of timing – you may know the trend is going to collapse but you don’t know when. It takes an incredible amount of arrogance and courage to go bearish. We’re, I think, right back in the same situation with China and resource stocks.

  8. Fantastic post. The wall is coming down.

    • Interloper says:

      Thank you, but honestly I’m not trying to start a revolution here. There are very few evil people in finance and a ton of the best people you’ve ever met who would take a bullet for their clients. it’s just that the temptations are much larger than average and the incentives are generally misaligned. I’m more trying to explain why things happen at this point.

  9. JB says:

    Such a great post, and so true. I have been in the financial industry for over 20yrs and worked at a top investment bank through the dotcom boom and bust. I studied bubbles and used to look at sites like itulip.com and was bearish throughout the whole thing much to the chagrin of market makers and my bosses who were always keen to remind me ‘there’s no money in being bearish’, my main problem as a broker was that I wasn’t good at lying, I couldn’t give my clients my analysts predictions when i thought they were worthless, and when asked what i thought the market was going to do I told the truth and not what they wanted to hear. The solution was simple, I got moved to the prop desk where my correct predictions wouldn’t do anyone any harm and could make the firm money.

    • Interloper says:

      Thanks JB, means more from someone who’s been there. I bet you lost clients who demanded more exposure to tech when you cautioned against. The propensity for clients to destroy themselves, and then blame their broker or sales rep, is a post I will definitely write.

      • cb3 says:

        What a great post. Please write about the propensity for clients to destroy themselves and blame their rep. I am a broker now and have been for the past 10 years. I want out of this racket actually. I am sitting on a mountain of cash for clients. It sucks because I am not getting paid on it. Morally though I have issues with putting money to work now. I think Europe is screwed and it will drag us down. I think next year will be an ugly year in the market. At best I think we rally to the 200 day moving average by year end. I would love to hear your market thoughts though. I have never seen such a desire to “yield whore.” before. Everytime I have seen that happens it ends badly. It makes sense becuase bond yields are so low, and baby boomers/retirees/preretirees generally have the most assets in retail. Many thanks.

  10. [...] sell side over-optimism explained as the trend fades (Interloper) [...]

  11. Shermanator says:

    We always used to talk about “blowing up” our clients with toxic securities like CMO’s and structured notes that research recommended. We felt bad when it happened, it meant we had to start cold calling again…

  12. [...] Bearish+wrong, or bullish+wrong. Guess which is worse for your career? (H/T Reformed [...]

  13. Jestyn says:

    Anyone remember Tony Dye?

    http://www.independent.co.uk/news/obituaries/tony-dye-controversial-fund-manager-796811.html

    Even worse than being the analyst who gets timing wrong, being the pension fund manager…

  14. [...] you think sell-side analysts are paid to be right you are sorely mistaken.  (The Interloper via [...]

  15. Michael says:

    Interloper – your post rings true more then than now, I believe. Given the rise in hedge funds, ETFs and HFT, enough stocks are being sold-short that a “sell to open” ticket is very similar (if not equal) to a “buy” ticket – in terms of the potential for commissions and repeat business. I’m constantly looking for “hedges” to my favorite long ideas… I would argue the sell-side is biased towards being positive mostly because the only real value they add (to the buy-side) is access to management. And while managements love watching their publicly traded stocks go up, they do not like to return the phone calls from analysts that have “Sell” ratings on their company. Also, you should remind readers that ratings can even be misleading given some are relative to the “market” and others are relative to the stock’s industry or sector. In the latter case, no sell-side analyst likes to waste time covering a crappy company – therefore the coverage list will be comprised of companies he or she believes will “outperform” peers in the sector.
    It is now and always will be a personal business. Investors should always do their own research and take ratings (and the obvious biases) with a grain of salt.

    • Interloper says:

      Fair enough. I’m hoping it was clear that that point was only a sideline to my argument in any event. As Kid Dynamite notes above though, there remains a significant amount of hand holding by Sales and Research to reaffirm ongoing trends/holdings. I would argue that most analysts and PMs in the resource space are watching Chanos out of one terrified eye, as an example.

      I take your point about ETFs increasing the profitability of sell orders.

  16. I think the difference is that most product claims are pretty close to reality and where these differ, ultimately, you are prevented from making them. Yes, in every other industry the bottom line is the same, but at least the difference between reality and outcome are not generally as wide. A bit like saying a loaf of bread will feed you, instead of finding out (or knowing before you sell it) that in fact it will suck you dry. A car is a car, a washing machine a washing machine, an audit an audit, but an investment is only ever sold on the basis that it will make you money within a relevant time frame. How many people would sell cars that they knew would blow up on the motorway and wreak carnage? Sometimes it does happen, but the manufacturer has to recall the offending item, replace it at no cost and if someone has been killed or injured, pay the appropriate damages. But then again, it takes two to tango and most investors hate to hear the truth too.

    “It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to heaven, we were all going direct the other way – in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only.”

    • Interloper says:

      Yeah, every case is different. The guy who sells a car who knows it will break down is an asshole. But, the seller of a fast car is not responsible if the driver goes too fast and crashes it.

  17. [...] The traders I talked with might not be seeing all the flows.  Or they might be longer (or shorter) than they’d like and are biasing their commentary accordingly.  Or maybe they’re distracted about something.  Or perhaps they’re angry with me for not pushing what they had to sell hard enough and freezing me out from the best intel they had. Everybody has an ax to grind. [...]

  18. [...] The traders I talked with might not be seeing all the flows.  Or they might be longer (or shorter) than they’d like and are biasing their commentary accordingly.  Or maybe they’re distracted about something.  Or perhaps they’re angry with me for not pushing what they had to sell hard enough and freezing me out from the best intel they had. Everybody has an ax to grind. [...]

  19. [...] The traders I talked with might not be seeing all the flows.  Or they might be longer (or shorter) than they’d like and are biasing their commentary accordingly.  Or maybe they’re distracted about something.  Or perhaps they’re angry with me for not pushing what they had to sell hard enough and freezing me out from the best intel they had. Everybody has an ax to grind. [...]

  20. [...] of the stocks cannot be winners.To complement that, I would recommend and excellent post here on sell-side over-optimism, which says some, I would say, sad truth about analysts who are more interested in getting their [...]

  21. [...] complement that, I would recommend and excellent post here on sell-side over-optimism, which says some, I would say, sad truth about analysts who are more interested in getting their [...]

  22. [...] complement that, I would recommend and excellent post here on sell-side over-optimism, which says some, I would say, sad truth about analysts who are more interested in getting their [...]

  23. What i don’t understood is actually how you are now not really much more well-preferred than you might be right now. You’re very intelligent. You realize therefore significantly with regards to this matter, produced me in my view consider it from so many varied angles. Its like women and men don’t seem to be fascinated unless it?s one thing to accomplish with Lady gaga! Your personal stuffs great. At all times care for it up!

  24. [...] For more on the topic of research, you really need to read The Interloper’s piece:  Sell Side Over-Optimism Explained As The Trend Fades. [...]

  25. [...] In one publication the analyst says “half-full”, the other “half-empty” and quickly leaking — sometimes only days later, as Josh Brown pointed out back in November. And all the while, the bank makes money on any movement of the pile cash they are custodian for. The Interloper has some great insights to the institutional side of this dance. [...]

  26. seo says:

    Wow! This blog looks just like my old one! It’s on a completely different topic but it has pretty much the same page layout and design. Excellent choice of colors!

  27. [...] and freezing me out from the best intel they had. Maybe they just didn’t care. Everybody has an ax to grind.  As a consequence, every interpretive conclusion is extremely tentative – of [...]

  28. [...] and freezing me out from the best intel they had. Maybe they just didn’t care. Everybody has an ax to grind.  As a consequence, every interpretive conclusion is extremely tentative – of [...]

  29. [...] Keeping one’s analysis and interpretation of the facts reasonably objective – since, again, analysis and interpretation are required for data to be actionable – is really, really hard even in the best of circumstances – even for scientists and especially in areas that don’t allow for ready testing and analysis.  Indeed, the recent scandal of retractions in scientific journals due to fraud and just plain error suggest that even testable scientific endeavors are more prone to error than was previously thought.  Everybody has an ax to grind.  [...]

  30. [...] abbildet, gilt als klarer Kontraindikator (einen interessanten Beitrag zu dem Thema gibt es hier). Sprich: Extrem hohe Werte sind bearish für den Aktienmarkt zu werten und umgekehrt. [...]

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