Don't Sell Street Analysts Short

Despite their current bad rep, they keep moving markets

Wall Street analysts have been called a lot of choice names lately, none of them too complimentary. But here's one that has been forgotten in the furor over the way greed and investment banking conflicts have tainted research: market movers.

Discredited they may be. But analysts' buy and sell ratings can still make or break a stock. "Wall Street analysts are not the only game in town, but they're a big game," says David Lichtblau, a vice-president at StarMine, which tracks analysts' work.

Overall, small research boutiques come up with better long-term picks, but big-name analysts from big-name banks have the most clout. For example, on Sept. 9, Prudential Securities Inc.'s Michael Mayo and Merrill Lynch & Co.'s Judah Kraushaar questioned J.P. Morgan Chase & Co.'s (JPM ) financial health. The stock fell nearly 10% that week and dived again days later, when the bank announced dud commercial loans had risen by $1 billion. The stock today trades at $15.45.

The market's response to Wall Street research is as strong as ever. On the day of an upgrade, stocks rise 2.1% on average; after a downgrade, they fall 5.4%, according to StarMine's database of about 25,000 recommendations--the same impact as during the bull market. Downgrades have more influence because bad news carries more weight with traders, says Lichtblau.

Why is the market still listening? Because any bit of company news is an opportunity to trade--especially in a skittish environment with investors hungry for direction. Unfortunately, the average investor can't always capitalize on the stock calls because they often take place after hours.

Changes in analyst ratings have the biggest impact on large and liquid stocks. On Oct. 8, Ford Motor Co.'s (F ) shares sank 9%, to $8, their lowest level in more than 10 years, after Credit Suisse First Boston (CSR ) cut them from outperform to neutral and halved its price target to $10. And because the changes often follow company news, they tend to exaggerate a stock's trend. For example, after Sears, Roebuck & Co. (S ) warned on Oct. 7 that third-quarter profits would be disappointing, downgrades hammered the shares 14%, to $32.

These days, investors, particularly institutions, hate to acknowledge the sway analysts still have. The fact remains that none of them can afford the $800 million a year the typical Wall Street giant spends on research. So they rely on analysts as a backup for their own legwork. "We visit the company first--but then check with the Street to make sure that there aren't any red flags," says Kenneth G. Mertz II, chief investment officer at Emerald Advisers Inc. in Lancaster, Pa., which manages $700 million.

Despite the bear market, sells are still rare, and vague ratings--such as overweight/cautious--are as difficult as ever to decode. However, recent redesigns of ratings are an improvement. Now, Morgan Stanley (MWD ) gives its lowest grade--underweight--to 21% of its recommendations, up from 3% before. Merrill Lynch limited its price forecasts to 12 months and cut its stock rating levels from six to three: buy, neutral, and sell.

Still, the heavy hitters are often off the mark. None of the handful of analysts who downgraded Enron Corp. before its December, 2001, bankruptcy was a top investment bank. Independent brokerage A.G. Edwards Inc. (AGE ) was the first national firm to sour on Enron, cutting it from a buy to a market perform on Oct. 19, 2001, according to Investars.com, which tracks analysts. By then, two small boutiques--Computrade Systems Inc. and Callard Asset Management--had issued sell ratings in April and August, respectively.

Clearly, the big players can spin profits for agile traders. But individual investors do better by following the boutiques. It just takes longer.

By Mara Der Hovanesian in New York

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