Cai Jin

Analysts turning bullish a cause for worry?

Merrill 'sell-side indicator' at highest level since 2011, so stock markets may trend lower

Global stock markets are in a jubilant mood, with widely watched market barometers such as the Dow Jones Industrial Average and S&P 500 hitting record highs almost daily.

The buoyant sentiment has rubbed off on the Singapore market. Chartists have noted that the benchmark Straits Times Index (STI) appears to have broken out of the downward trend it had been stuck in since July. This may cause it to swing towards the 3,300 resistance level. It closed 29.45 points higher at 3,291.29 on Friday.

Similarly, fund flow data furnished by the Singapore Exchange (SGX) paints a bullish picture. For the week ended Sept 29, institutional investors bought a net $485.9 million worth of SGX-listed shares. This marked their biggest weekly purchases here since early April when a re-rating of the local banks following their better-than-expected year-end results caused a stampede into their shares.

As it turns out, their love affair with the local lenders hasn't faded. Their latest weekly purchases were concentrated mostly in DBS Group Holdings, OCBC Bank, United Overseas Bank - and one other STI component counter, telco giant Singtel.

Yet for all the exuberance displayed by fund managers, many investors are still wary of dipping their toes into the stock market. If anything, they are more wary than ever.

And they cannot be blamed for their edginess, as there are a number of reasons to be cautious.

When times are bullish and fund managers are on the lookout for good investment ideas, that is also when analysts are at their most bullish. This is because it is easier to get access to management when they give its company a 'buy' call. And their ultimate clients, the fund manager, would usually want to have access to management in order to speak to them. That may translate into a trade if their client is impressed with the company.

These include sabre-rattling by North Korean dictator Kim Jong Un and American President Donald Trump, eerily quiet trading conditions despite the buoyant stock prices and the move initiated by the United States central bank to drain the vast liquidity that it had poured into the financial system since the global financial crisis eight years ago. In a recent report, US investment bank Bank of America Merrill Lynch believes that the growing cheerfulness of stock analysts may also be a concern.

It has an indicator called the "sell-side indicator" that measures Wall Street's bullishness based on recommendations given by stock analysts to clients. This indicator is now at its highest level since 2011.

What is interesting about the indicator is that when it is low, there is a very strong likelihood that stock markets would trend higher in the subsequent 12 months. But when the "sell-side indicator" rises, stock markets tend to trend lower subsequently.

Why should this be so? One great investor I like to quote is Sir John Templeton, who once observed that bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria.

And stock analysts, whose firms make money from trading and investment banking, are notoriously bullish to start with. So if they get even more bullish than their usual self, some investors would interpret this as a strong sell signal.

To understand why, let's review what an analyst does. He works hard to produce a report, sometimes fairly detailed, sometimes with a unique perspective to give investors an update on a company, almost always with a "buy", "hold" or "sell" recommendation attached to it.

The report is then given to the sales team in the brokerage or bank, which then relays the message to clients.

In many cases, the top clients are large fund-management firms and often the ones who pay the most commission dollars.

If a fund manager finds the report interesting, he may place an order with the brokerage that issued the research report. That is how analysts get paid for their efforts.

These institutional clients are interested only in the biggest stocks by market value and most-liquid counters, which explains why research is geared towards STI component counters that make up a big chunk of the daily trades.

So for analysts, it is not a question of picking stocks with the biggest potential for gains, but rather counters their clients are more likely to like - and which they feel more positive about in order to make the sales dollar.

To them, it is also more fun to be bullish and right, saying positive stuff and finding the stock going up after they rate it a "buy", with clients lionising them for making the right calls.

When times are bullish and fund managers are on the lookout for good investment ideas, that is also when analysts are at their most bullish.

This is because it is easier to get access to management when they give its company a "buy" call. And their ultimate clients, the fund manager, would usually want to have access to management in order to speak to them. That may translate into a trade if their client is impressed with the company.

Besides generating commission dollars from the orders given by their clients, most brokerages also get compensated for deals such as placing out new shares issued by listed firms to investors.

An analyst can't be paid directly from such deals, but he knows that the more positive he is, the more likely the listed firm may choose to do business with his company.

After all, which analyst would such management want to go on roadshows with to sell shares? More often than not, they would prefer someone who is positive on the stock.

And in good times, there is increased likelihood of such deals materialising as companies raise money to expand their business or engage in merger and acquisition activities, using the brokerage as their financial adviser.

So it was no surprise last year when The Economist magazine observed that even though 30 per cent of the S&P 500 companies at that time had yielded negative returns, 49 per cent of them were rated "buy", 45 per cent "hold" and just 6 per cent were rated "sell".

It said: "Analysts can look at comparable companies to glean reasonable profit estimates, and then work backwards from their conclusions.

"Or they can simply echo what their peers are saying and follow the herd. Or, most important, they can simply ask the company they are following what their actual earnings numbers are."

Analysts also have an incentive to issue ever-so-slightly pessimistic forecasts, so that companies can "beat" expectations, with profits exceeding short-term forecasts around 70 per cent of the time since the global financial crisis, it added.

These observations give some credence to Merrill's "sell-side indicator" as a good gauge on how likely the market is to move.

The redeeming feature is that despite the spurt of enthusiasm from analysts, the indicator has moved back to what is deemed "neutral" territory after having sat in "bearish" mode, which has, of course, been a period of stellar gains in the stock market.

But as Sir John noted, bull markets die on euphoria. We have, by no means, reached the end of the current bull run yet. But Merrill's "sell-side indicator" bears watching if it shows signs of further exuberance.

• Goh Eng Yeow has a new book Market Smart: How To Grow Your Wealth In An Uncertain World. See ST journalist launches new book of columns

A version of this article appeared in the print edition of The Straits Times on October 09, 2017, with the headline 'Analysts turning bullish a cause for worry?'. Print Edition | Subscribe