Trading On Analyst Recommendations

I recently read a post on themotleyfool.com entitled The Simple Way to Beat the Market. The author, Dan Caplinger, suggested you can beat the market by trading on analyst upgrades and downgrades.

His chart compared the performance of seven stocks versus the S&P 500 on the same day that analyst recommendations were announced. The sample was taken from March 30 – April 2.

Photo by kevinzhengli, courtesy of flickr

Morgan Stanley (MS), Autozone (AZO), Apollo Group (APOL), The Knot (KNOT) and Mosaic (MOS) were downgraded while Microsoft (MSFT) and Alcoa (AA) were upgraded.

The stocks that were downgraded underperformed the S&P 500 and the upgraded stocks outperformed the S&P 500.

Seems very simple, but it is not. If it was, then fund managers would do it and you wouldn’t see 70 percent of them failing to beat the market.

There are a few snags with this plan: time, time and time again.

Time – Research shows that markets react to new news within 15-3o minutes of release. Do you have the time and flexibility to wait for announcements and place trades immediately afterward?

Time – The same result doesn’t happen every time. Upgraded and downgraded stocks do not always move with the direction of the recommendation. Even if they did, the recommendations do not impact each stock to the same extent.

For instance, Apollo and Morgan Stanley were both downgraded from Outperform to Neutral, but the stocks lost 15.2 and 2.6 percent, respectively.

Time again – When should you sell? If you take a look at the charts, it could be more profitable to hold on to the stocks for more time. Take a look at this chart for the two stocks that were upgraded. One month after the upgrades, they are both outperforming the S&P 500.

There are several potential pitfalls of trading on analyst coverage. It can be profitable, but it is not a sure thing and it is not simple!