Confluence of Interest

Or how we can turn analysts from ill-disguised shills to people we can afford to trust.

Everyone on and most people off Wall Street know that, whether they like it or not, analysts are in the publicity business; since their views and pronouncements drive stock prices, and since they're theoretically in the best possible position to gather information, they become the gatekeepers for just about any prognostications about a company. Companies realize this, of course, and put the analysts in a tough position: Say nice stuff about us, and we'll feed you information to back it up; ask the wrong questions, and we'll freeze you out, fake you out (offer deceptively bad news before announcing good news, in the hopes that the analyst will offer an ill-timed downgrade), and use you as an example for the rest.

Of course, there have been worse abuses: In the 1980's, some fund managers at Drexel got 'the blessing' -- the day they finished buying a stock, Drexel's analyst would coincidentally discover that the company was a strong buy. And around the same time, it was simply a matter of good business sense that a good analyst told his firm's best clients what the firm planned on doing next (in Market Wizards, Michael Steinhardt discusses this without even hinting that it might be unseemly). And finally, there's the ever-present possibility that, like thousands of fly-by-night promoters, the analyst could simply buy stock in what he's touting and sell into the runup.

The rules have changed, and most of these practices just aren't worth the risks. Now, when an investor reads a junk fax touting a stock that the faxer happens to have $50,000 worth of options on, he'll either throw it away or keep it for entertainment value (and the fine print notes that, since it's a paid promotion, it is to be viewed as entertainment, and not advice). An analyst is forbidden from trading in what he touts, and most simply don't trade (I'm a Catholic, so I can note with impunity that this is oddly reminiscent of the notion that someone who has taken a vow of chastity is the first guy you should ask for advice in your relationships).

But is there a better way? I ask because the answer is "Yes," and rhetorical questions are absolutely crucial, sometimes. Aren't they? Anyway, rather than demand that analysts not trade, why not give them the option of being legally obligated to follow their own advice? If someone tracked ten semiconductor stocks, and had five 'sells' and five 'buys', he'd have an equal-weighted portfolio of five shorts and five longs. Just to keep traders from manipulating the market or getting run over by an overreaction, they'd need to put half their order in before the recommendation went out, and half after. And imagine how reliable they'd be! No longer would the seers and pundits of Wall Street have nothing on the line but this year's ranking in Institutional Investor -- one screwup could mean that they don't get to retire.

This would also rid us of one of my least favorite habits of analysts: The 'relative performance' game. It was pretty popular in 2001 and 2002 -- they'd go on TV explain that you might have lost 80% of your money because you put it in Yahoo! and Intel, but somebody who had Inktomi and Redback lost even more. In the psuedo-utopia I'd hope for here, the analyst would either a) Have told his clients to short the stocks he hated, or b) Be too poor to afford anything he'd dare be seen wearing on TV, thus rendering the hypothetical anecdote moot.

I'd still leave open the option to be a financial eunuch and eschew trading altogether, but from an investor's perspective those who didn't back up their recommendations with cash wouldn't be seen as reliable and might, in fact, be presumed dishonest. And the 'access' question? This one's trickier, because once again management has every incentive to disinform negative analysts. But when an analyst has nothing on the line, he has no real incentive to dig deeper -- when it's his money, he'll be involved in a constant effort not to be part of the profit derived from someone else's short squeeze.

And while we're dealing with conflicts of interest, you might ask what's in it for me, your humble author. Nothing. And less. I try to make money from market stupidity, and a great deal of that stupidity results from pundits who have no real stake in what they're saying. If that changed, I'd have far fewer chances to make a buck. Worry not, though; I'm safe. Who, after all, listens to me?