Sorry, Too Many Buy Recommendations

Merrill Lynch is apparently now going to require stock analysts at their firm to issue underperform ratings on at least 20% of the companies they cover. Right now, Wall Street analysts on average only give about 5% of companies an underperform rating. Merrill will also limit buy ratings to 70% of the companies covered, as well as limit neutral ratings to 30%. Analysts at Merrill now recommend sells on about 12% of the stocks followed.

Beyond making few sell recommendations, understanding exactly what underperform means has also be inconsistent between brokerage houses. As a result, Merrill Lynch has also further defined its ratings. Now, underperform will be the lowest rating and will apply to stocks that are expected to have a negative total return over 12 months, or gain the least among stocks in the same industry. Neutral stocks are projected to return up to 10% (doesn't sound neutral to me), while a buy rating will apply to companies that are expected to return more than 10%.

What does this mean? Essentially, 1 in 5 companies that Merrill covers will be a dog. A full 20% of the analysts covering stocks will be looking for the companies that don't quiet make the grade. So why is Merrill Lynch making these changes? Are they bowing to the pressure put in motion by Eliot Spitzer back in 2003? Is John Thain being influenced from his experience at the NYSE? Maybe, but more than likely it is about money, and not just lawsuits. During any volatile market, especially one that has the overhang of housing, credit, and inflation issues, not to mention the potential recession talk, investors and traders are interested in what to sell. Buying is easy, selling is harder. Sell guidance is valuable, especially in our current environment.

But can Merrill make money letting clients know what to sell, especially if those same clients were already advised by the company as to what to buy? Certainly valuable to the client, but probably not as value adding to Merrill. Yet, recent data from Bespoke Investment Group showed that over 10% of the shares available for trading are sold short. Given that over 1/3 of all stocks fall each year on average, providing sell data could be profitable for those willing to paying up for it - i.e., hedge funds. Of course, providing sell data is not without its own cost. Investment banks in the past have been opposed to providing too many sell recommendations, worried that they may offend potential or current clients that they hope to do business with. As such, while being potentially profitable for sale to hedge funds, expect the sell recommendations to also be filtered somewhat, avoiding upsetting the investment banking apple cart.