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The One Thing Wall Street Does
Much Better than the KGB

By Andrew Gordon

How dumb would it be to make investments based solely on the sacred pronouncements coming out of Wall Street?

You’d be better off listening to the KGB (now called the Federal Security Service, or FSB). If you did, you’d know that the CIA was involved in the assassination of President Kennedy and that U.S. forces used chemical and biological weapons in the Korean War. These are just two of hundreds of successful “disinformation” campaigns waged by the government of the Soviet Union against the U.S. and its European allies.

But the information coming out of Wall Street makes the KGB look like rank amateurs. Consider the following:

• In a Bloomberg article, John Dorfman writes that over the past nine years, the four companies with the most “buy” recommendations from Wall Street analysts have lost an average of 3.7 percent per year. The four companies with the most “sell” recommendations did slightly better, losing 0.2 percent per year. During this period, the S&P 500 averaged a 7.4-percent gain per year.

Last year was more of the same. The four “loved” companies gained an average of 2.4 percent against the nearly 16 percent enjoyed by the S&P 500. The four “unloved” stocks? They went up an average of 21 percent last year.

• In 2000, all 12 of the biggest firms on Wall Street agreed that the U.S. market would rally the following year. In 2001, the S&P 500 dropped 13 percent. The next time all 12 were bullish about the year ahead? The end of 2006.

• A Merrill Lynch survey at the beginning of 2006 showed that fund managers were betting heavily on tech, and betting against telecoms, utilities, and real estate. Telecom and utilities had pretty good years. And real estate jumped 33 percent to lead all sectors. The tech sector, however, dragged.

What the heck is going on here? How can Wall Street be so wrong so often?

I can only paraphrase Warren Buffet, chairman of Berkshire Hathaway (BRK), "A herd of lemmings looks like a pack of individualists compared with Wall Street once it gets a concept in its teeth."

That’s as good a theory as any. But I have another one. And it paraphrases a well-known saying: With friends like the ones from Wall Street, who needs enemies?

The curse of any company is to have all of Wall Street on its side. You see, those high expectations are already built into the stock price. It’s a rare company that can consistently exceed such high expectations quarter after quarter. If it can – as Google (GOOG) has mostly done – everybody wants to buy those shares, which pushes prices up further and raises expectations even more. That’s why when richly valued companies fall, they fall hard.

My colleague Rick Pendergraft agrees with this theory, although he puts it differently. He points out that when all recommendations are “buys” on a stock, there’s no room for analyst upgrades, even if the company continues to perform well. But if the company misses an earnings guidance or something else goes wrong, some of those “buys” can turn into downgrades that will drive the share price down in a hurry.

Even when Wall Street strategists see the edge of the cliff ahead, they may mutter “uh oh,” but they forge right ahead anyway. David Kotok oversees an $850 million fund at Cumberland Advisors Inc. He’s noticed how supremely optimistic everybody is about the market, “I’m an old believer that when everyone believes something is going to happen, the opposite happens. That causes me concern, because I’m bullish too.”

Warren Buffet describes this behavior as well as anyone, but explaining such “bull” headedness? I believe Jay Edward Epstein, who wrote a book about the KGB and its deceptive ways, has the best handle on it: “the target of disinformation ... must be in a state of mind to want deception."

Who wouldn’t love to see a bull grab the market by the horns this year and raise it to new heights? We can hope it happens, but count on it? Please don’t. In fact, count on it not happening. That way, you’ll be prepared for the worst.

One way to prepare is to invest in solid dividend-paying companies. When things get dicey, that’s where a major portion of investment money goes. But why wait for things to get dicey? Do it now because tomorrow may bring stormy weather, especially if Wall Street expects it to be warm and sunny.

Good Investing,
Andrew Gordon