How To Forecast Stock Price? – Explained Using Example

Analyst recommendations and the beauty contest problem

Sell side analysts employed by brokerages publish their coverage on stocks periodically. Since forecasting stock prices cannot be considered an exact science by any stretch of imagination, what determines their opinions?

Some of the parameters considered are (not an exhaustive list by any measure):

  • Trend in operating performance
  • Business prospects (dispatches, order books, et al)
  • How macro factors are playing out
  • General Market direction
  • Managerial guidance
  • Discussions with the company on its business plans/prospects

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One aspect the attentive amongst may have noticed is the remarkable consistency in recommendations, whether ‘Buy’ or ‘Sell’. A case in point is coverage of cyclical stocks, like for eg. Tata Steel. If one looked at the ratio of buy:sell recommendations, it was at very high levels in December 2007 when the stock was at an all time high of 900+ levels. On the flip side, the ratio of sell:buy recommendations was at very high levels in November 2008 when the stock was near its all time low of ~150! No contrarian views from most of the analysts despite the huge deviation from fundamental and historical values!

This begs the question: do  analysts, by and large, have a view of their own? Answer is no and there is a logical reason behind it. It refers back to Keynes’ ‘Beauty Contest Problem’.

In 1936, Keynes compared the stock market to a beauty contest. He described a newspaper contest in which 100 photographs of faces were displayed. The winner would be the reader whose list of six came closest to the most popular of the combined lists of all readers. The best strategy, Keynes noted, isn’t to pick the faces that are your personal favorites. It is to select those that you think others will think prettiest:

“It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligence to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.” (Keynes, General Theory of Employment Interest and Money, 1936).

Similarly in markets, he said, you win not by picking the soundest investment, but by picking the investment that others, who are playing the same game, will buy.

Crazy as this game is, we are all here to play it and we play it by the market’s rules. Besides, incentives are skewed: one of the cardinal rules is that it is alright to be wrong on the side of the market. This removes incentive to go contrarian lest the call taken against the market goes wrong. God save the contrarian analyst who gets his/her buy or sell recommendation wrong. Whereas, if the recommendation is in line with the ‘average’ and turns out to be wrong, it is inherently justified since it was ‘in line’.

Good luck in picking your beauties!

Also Read How Psychology affects Trading

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