Follow The Wall Street Pros if You Want to Lose Money

by Marc Lichtenfeld, Investment U’s Senior Analyst
Wednesday, August 3, 2011: Issue #1570

My level of frustration over the weekend seemed to grow with every passing hour. I was furious that it looked like partisan politics were going to create a financial crisis that didn’t need to happen.

But there was something else that had my blood boiling. An issue that still hasn’t been addressed. Even with this recent reprieve, Standard & Poor’s and Moody’s (NYSE: MCO) are still threatening a downgrade.

If the United States loses its AAA rating, interest rates will rise, unemployment will likely go higher and the economy will tank.

It’s not the government’s lack of fiscal responsibility that irks me (well, it does, but not for the purposes of this column). It’s the fact that Standard & Poor’s and Moody’s still have the ability to not only move markets, but also to directly affect every citizen of this country (as well as others).

Aren’t these the same guys who completely missed the boat on the mortgage meltdown?

The AAA rating that the agencies threaten to take away is the same rating that they gave to mortgage-backed securities that were backed by subprime loans. The agencies never bothered to learn what the securities actually consisted of.

So in other words, the full faith and credit of the United States may get a lower rating as securitized subprime mortgages taken out by day laborers making $14,000 per year.

Now, I get the United States has some problems. But it was unlikely that the United States was actually going to default and leave bond holders without principal or interest payments.

The fact that they have any credibility and influence really aggravates me.

But I’m not surprised…

Wall Street Analysts Still Have Power

Analysts who, in the past, rated stocks a “Buy” despite really thinking they were garbage, still have the power to move share prices with upgrades and downgrades.

That’s equally as befuddling, considering how often they’re wrong.

Consider: In March 2009, Wall Street analysts recommended that 51 percent of your portfolio be invested in stocks – the second-lowest level in 12 years. Of course, March 2009 was the bottom of the market.

The peak stock recommendation by Wall Street analysts was in April 2001, well after the market topped a year earlier.

According to Businessweek:

  • From March 2009 (the bottom) to January 2010, stocks that were the favorites of analysts climbed 73 percent. Not bad.
  • Stocks that were their least favorites jumped 165 percent.

As a result, market success often comes by going in the opposite direction of these Wrong Way Corrigans (just ask the few hedge fund managers that shorted the AAA-rated subprime-backed securities).

One of the reasons is that as these analysts are proven wrong, they often play catch-up by upgrading the stock, providing more fuel to the upside.

So I like to look for stocks where the majority of analysts don’t rate the stock a “Buy.”

One of my favorite names in this category is Fastenal (Nasdaq: FAST).

Fastenal makes nuts, bolts and other industrial and construction supplies. Not surprisingly, in this economy, few analysts are bullish. In fact, only four out of 11 rate it a “Buy.”

However, despite the sluggish economic environment, Fastenal has been growing its businesses.

  • Earnings and revenue growth have been strong the past two quarters, margins are improving and the company plans to hire up to 200 people per month for the foreseeable future.
  • It has no debt and a two-percent yield.

This is just another example of where I expect the analysts to be wrong.

But it’s not just the analysts who aren’t making you money – mutual fund managers notoriously underperform the market.

You Have the Power to Ignore Wall Street Analysts

Various studies have shown that approximately 80 percent of mutual funds underperform their benchmarks in any given year and that the average fund underperforms by two percent or more.

And in many of those cases, you’re paying for the privilege of underperformance. Some mutual funds have loads (up-front fees) of five percent or more, meaning you’re only investing $95 out of every $100 you hand over to them.

Even the no-load funds have average expense ratios of 1.3 percent to 1.5 percent, meaning the fund has to beat the market by that amount in order to provide market returns net of fees.

And if the market goes down five percent but the mutual fund only loses four percent, they’re thrilled because they beat the market. Doesn’t matter to them that you are down four percent. But I bet you don’t care that they beat the market, you only care about the four percent that you lost.

There are various reasons why the analysts and fund managers’ performance is so bad. I’ll be sure to follow up on this point in the near future.

But for now, know this: Following the Wall Street pros is usually the worst thing you can do – unless, of course, your goal is to lose money.

Good investing,

Marc Lichtenfeld