Most equity analysts play it safe rather than risk their reputation - and possibly their career
A stock downgrade is more likely to be followed by another downgrade.
Shares of Apple $(AAPL)$ - already down 20% since the beginning of the year - are likely to fall even further in coming months.
That prediction is based on the behavior of Wall Street analysts, who tend to react slowly to developments. Seven of the almost 50 analysts who regularly follow Apple's stock have downgraded it this year. That leaves a large group of analysts who potentially could join this group of seven, and whose downgrades could cause Apple's stock to fall even further.
Analysts' sluggishness in responding to new information is tied to their career and compensation incentives. It's risky for them to deviate too far from the Wall Street consensus. If they're wrong, their reputation will suffer and they possibly could lose their job. As such, they are inclined to keep their earnings estimates and buy-hold-sell ratings in the middle of the pack.
This herd instinct was famously described by the late British economist John Maynard Keynes as "worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally."
This theory of analyst behavior leads to a number of empirical predictions that have been borne out by research. One, as confirmed by this study, is that a downgrade of a given stock is more likely to be followed by another downgrade rather than an upgrade - and vice versa.
This phenomenon is illustrated by the chart above, which plots the number of downgrades and upgrades of Apple stock over the trailing six months. Notice the preponderance of downgrades (the red columns) over the past few months.
Another consequence of analyst sluggishness is that the stock market reacts more quickly than analysts to developments that affect a company's prospects. One study, for example, found that the analyst consensus on a given stock reflects just two-thirds of the information that the market itself has already taken into account.
You might conclude from this result that equity analyst upgrades and downgrades should simply be ignored, since there would be no role for them to play if the stock market has already discounted all relevant new information. But the stock market isn't that perfect. Researchers have found that as analysts finally take into account the information the market has already incorporated, prices move even more.
This is why it's a good bet there will be more downgrades of Apple stock in the coming months - and why shareholders will suffer even more than they have already.
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