Savvy traders will study price action within the context of prevailing analyst sentiment
Here at Schaeffer's, we often cover analyst ratings and the impact they can have on the affected stock. Just this week, for instance, we looked into how shares of fast food giant Wendy's (WEN) and blue chip Caterpillar (CAT) responded to downgrades, so now is as good of a time as ever to dive deeper into what analyst ratings truly are, and what they mean.
An analyst rating is a recommendation to buy, hold, or sell a given stock, based on multiple factors -- such as a company's earnings and revenue history, product pipeline, share price performance, and more. These ratings can range from bullish ("strong buy" and "buy"), to neutral ("hold"), to bearish ("sell" and "strong sell"). As a whole, a stock's analyst ratings configuration can tell us at a glance how Wall Street feels toward that particular name.
Analyst ratings are changed via publicly issued upgrades and downgrades, which are often sparked by corporate events (such as product launches, shareholder meetings, or earnings reports). However, for various reasons, analysts can be slow -- or outright reluctant -- to change their ratings in response to a stock's evolving price trend.
The Contrarian Take on Analyst Ratings
Given that Wall Street analysts are the "experts" on the stocks they rank, it can be tempting for investors (and particularly those who are newer to trading) to defer to the big brokerage firms' bullish or bearish opinions. However, at Schaeffer's we often take a contrarian approach.
That doesn't mean we blindly bet against Wall Street analysts, though. Instead, we look for situations where a stock's price action appears to be out of sync with analyst ratings, which can create tradable opportunities.
Identifying a Bearish Signal from a Contrarian Perspective
When a stock is trending lower and underperforming on the charts, you would expect to see a relatively higher percentage of "hold" and "sell" ratings from analysts. So, when we spot a downtrending stock with a high proportion of "buy" and/or "strong buy" ratings, we'd consider that stock to be extremely vulnerable to future downgrades, as analysts eventually adjust their ratings to reflect the poor price performance.
Since downgrades often result in fresh selling pressure for the affected stock, the prospect of future bearish analyst notes hints at additional downside ahead. When combined with a thorough review of other key technical, fundamental, and sentiment indicators, a high number of "buy" ratings on a lagging stock can be an effective contrarian sell signal.
Identifying a Bullish Signal from a Contrarian Perspective
By contrast, a stock that is outperforming on the charts, but mainly sports "sell" or "hold" ratings from analysts, would represent a bullish contrarian opportunity. As analysts gradually respond to the stock's positive price trend with upgrades, those research notes can draw new buyers to the stock, effectively perpetuating its uptrend.
In summary, the key to correctly identifying a contrarian bullish or bearish signal relies on a thorough analysis of the stock's price action within the context of the prevailing sentiment among traders and analysts. Whenever a strongly uptrending stock is lacking in "buy" ratings, or a declining stock still carries a glut of "buys," savvy contrarians can take advantage by betting that analysts will eventually be forced to capitulate to the reality of the stock's price performance.