The Market for Financial Research & Analysis – A Mental Model
I have, for just over the past month, had the opportunity to consume the weekly macroeconomic research reports of an analyst at a well-respected brokerage firm, and recent shifts in the directional thrust of one of his more important prediction areas has offered further evidence underpinning my mental model of the market for this kind of service in general. The man in question spent most of January fretting over the eventual initiation of a fourth round of quantitative easing in the United States; hopefully this seems as insane to you as it does to me. I am terrified the Fed will tighten too early (really we should be willing to tolerate a few years of, I dunno, 4% inflation just to move us away from the ZLB), so it’s not that I’m necessarily opposed to QE-more (though I’d rather Yellen just leave rates where they are for a while), but to suggest that it is actually likely requires a comprehensive ignorance of the Fed’s own statements on future rate policy and an odd, to put it lightly, interpretation of recent U.S. economic data.
Perhaps recognizing this, the analyst in question finally this last week appears to have updated his thinking, in that the references to additional loosening via QE-4 have been dropped and all of a sudden (and with no acknowledgement of this swift turnaround) he instead addresses the potential effects of eventual Fed tightening. Only now that the contrarian view is really truly untenable has he excluded it from his analysis.
Now combine this with the language you frequently see in job postings for, say, equity research analysts. There’s often an expressed desire for “creative thinkers” or people capable of “outside-the-box analysis”, which has always struck me as a little odd. Like, there are only so many ways for Lockheed to generate income over the relevant timeline of a DCF, and there are only so many things that can affect its bottom line. If you’re a money manager, how much do you really want a creative analysis? “Lockheed could do well marketing GPS solutions to farmers” might be true, but that seems like the kind of idea that’s more useful if you work at McKinsey than if you work at Fidelity. Basically, fuck creativity – you just have to be right. And most of the time being right is boring and straightforward. I rather suspect there just aren’t that many financial questions where the right answer also happens to be some unbelievably creative one that only a mad genius would have come up with.
My explanation for this state of affairs, in which being sort of ostentatiously wrong or demonstrably creative is somehow valuable (and more so than being correct), is as follows: as long as you don’t have any money on the line yourself (e.g. you are a sell-side analyst), it is better to be mostly wrong, but in creative individuating ways, so that when you are right, it is in a way that nobody would have ever seen coming. Being right 99% of the time and missing the shockingly unexpected calls along with everyone else provides no value to clients. If you are a money manager, you have your own methods for gathering and processing information and your own mental (or Excel, I suppose) models of how much to weight it all, so you are content to pay for what is, on a percentage basis, consistently shitty analysis because the right-ness of it is not what is actually useful to you. Instead, what you’re paying for is the embedded impetus to at least consider an investment thesis you hadn’t thought of before.
I think it’s reasonable to ask if this is really a socially optimal thing, that there seems to be fairly little accountability for having your predictions be actually useful as predictions.* On the other hand, if asset managers really wanted reliable directional intelligence for every security they might purchase and not, say, just intriguing possibilities, then probably they would already pay for it? This is perhaps a bit of a Panglossian view of the market for sell-side research (maybe there are profound structural biases at work preventing buy-side clients from getting the research they truly want?), but I kind of doubt it. It would be a bit odd if by now the supply of information had not evolved at least slightly to conform to the demands of the people paying for it.
*This whole post dovetails with the idea that sell-side analysts are valuable for the access to management they can facilitate and not for the actual information/opinions they provide on the stocks they cover – see Matt Levine here: “You could have a model where the best thing that a research analyst could do for his investing clients is put a “buy” on every stock he covers, so as to get lots of management access and let his clients decide for themselves. This works better for big clients than retail ones of course.”