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.