Mining giant Glencore, and its Australian counterparts Rio Tinto and BHP have today gained back some of the billions of dollars wiped off their market capitalisation this week following a negative research note from a London-based analyst.
In his note, Investec mining analyst Hunter Hill reportedly wrote that if commodity prices remained at current levels, almost all of Glencore’s value could be wiped out unless the company undertook a major restructure. In the hours following the release of the note, Glencore saw its shares plunge by 30%.
Stock market prices have long been recognised as being more volatile than is really justified by the underlying performance of the companies. Company profitability changes slowly but stock prices jump around every day.
There are many reasons for this excessive volatility. An important one to recognise is that the stock market is basically a market for second hand goods: the only way one can normally buy a stock is to buy it from an existing seller. So stock market volatility can be driven both by changes in the willingness of buyers to purchase and also by changes in the willingness of owners to sell.
Prices swing a lot because at the very time buyers are keen, thinking they have seen value in a stock, the existing owners suspect the value has gone up and hence are less willing to sell. Essentially supply goes down when demand goes up, causing a price spike. Equally at the very time when sellers want to unload stock, buyers flee the market.
Perceptions and fear
Both supply and demand then are driven by people’s perception of value. The main component of this perception is the actual performance of the company concerned. When people perceive that China might demand less steel, they expect this to lead to lower profit for iron ore producers, and hence mark down the value of the stock concerned.
One of the key roles of market analysts is to understand the businesses in the sector they focus on, to understand market conditions, to review the quality of management, etc, and to form a view on the fair value of a stock. Part of their role is to make markets operate more efficiently by revealing what they consider to be true prices. They convey this information to their clients, who then move to buy (or sell) the stock concerned, which leads to its price rising (or falling). Virtually all analysts will have at some time moved the market in a particular stock.
Of course when you or I see the price of the stock concerned rising (or falling), all we know is that someone has started to buy (sell) it. We do not have access to the particular analyst’s recommendation. Seeing the price move up we suspect that someone has done some analysis and realised it is under-priced. We infer that a price moving up means the stock concerned is undervalued, and a price moving down means it is overvalued, and buy or sell accordingly. This creates a momentum effect. It mainly involves uninformed investors following a trend. It can add to the wild gyrations of the market and its tendency to overshoot and undershoot. Automatic computerised trading can have similar effects.
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Analysts are not immune to momentum effects. There is a fair bit of evidence that analysts tend to herd in the sense that their recommendations tend to move together. This can be explained by a human tendency to prefer not to be exposed as an outlier unless one is very sure of one’s prediction. It’s like the old adage that no one ever got sacked for buying IBM computers.
There is also evidence that the performance of star analysts declines when they move to other businesses. They might be right a couple of times, whether because of skill or luck, but this outperformance does not usually persist over time or across employers. There is also a lot of evidence that fund managers who follow stock recommendations and invest consistently find it very hard to perform better than the market average for any sustained period.
Equity strategists play a similar role to analysts but focus on whole markets or market segments. Anticipating a fall in the Australian dollar, equity strategists will probably have suggested people move their portfolios from the resources sector to the retail, construction or banking sectors. Some will be bullish on emerging markets, some on the US, others look at currencies, and so on. Functionally they are doing the same sorts of things as stock analysts, just looking at investible categories rather than companies. And they can have similar impacts.
So, can analysts move markets? Yes, they can when they bring new information or additional insights to valuations. They perform an important role in pointing out mis-priced stock. There is much less evidence that they can do so consistently, and it is very difficult to make excess return from following the advice of even the best when trading costs are taken into account.