Using Analyst Upgrades And Downgrades To Trade Stocks

A quick disclaimer – this post is about trading stocks and NOT investing in stocks for the long-term.  As I get myself back into the stock market, I find it kind of interesting watching the daily movers, trying to learn what causes a stock to “POP” or “DROP”.

I have come to realize that a huge majority of the volatility in a stock price is due to humans, emotions and the internet.  Another big factor in whether or not stocks move is due to the Analysts and their upgrades or downgrades of a stock which makes me wonder, why do stock market analysts and these big investment companies issue upgrades and downgrades?

Why Stock Market Analysts Issue Upgrades and Downgrades

You can’t forget that stock market analysts work for big companies whose main goal is to make money hand over fist.  This makes me wonder if a stock market company has done the research, found a great stock, why do they want to let everyone in on all the hard work they have performed?

The answer is because they want to make money.  If I have found a stock that I think is going higher I’m going to buy into the stock, and then tell everyone how awesome the stock is in hopes that they too purchase the stock which drives up the price.

The key point here is that the analyst issuing the upgrade and price target will typically already own shares of the company and probably sell the stock before it hits the target price they told you about. It’s all kind of a game, but it is a game I think we can play.

How To Trade Analyst Upgrades and Downgrades

Trading analyst upgrades and downgrades should be quite simple.  For this scenario, we are not even going to go in-depth on the company, the financials or anything like that.  We’re going to focus on short-term emotions and trade the human aspect of the market.

Lets Use GM as an Example

We’re selecting GM because it is a relatively safe stock.  It is sitting close to an all-time low, has over a 3% yield, Warren Buffet has a large stake in the company and Goldman Sachs has initiated a “Buy” rating with a target price of $49.

Without taking even a peek at their financials, I know we can make an easy 20% on this stock over the next few quarters and here’s why.  GM currently trades at $30/share – which is close to 66% below the 12-month target price.  Now Goldman Sachs buy rating on the stock combined with the $49 price target tells me they will do most everything in their power to help the stock rise to around those levels.  Will it hit $49?  Probably not.  But will it hit $36 – odds are it will simply due to the fact the short-term buy rating and price target will push it up past $40.

This is where the emotions come into play.  Goldman Sachs has publicly published this price target and don’t think other investors are looking at Goldman’s ratings and targets.  A stock with a $49 price target still looks attractive at $40, yet we’d already have bought and sold it and made our 20% – which is a great return.

What I’m trying to say here is that short-term market strategies should be based on human emotion, motives and logic.  If a company puts a “BUY” rating on a stock they want it to pop and go up so they can sell it.  If they put a “SELL” rating on a stock, they may want it to take a dip so they can purchase more on the cheap.

All of these different schemes and short-sighted market tactics need to be taken into account when you’re trading.  You need to look at these Analyst upgrades and downgrades with a different set of eyes and try to figure out what the goal was.

I have seem stocks plummet and then an analyst comes out with a reiteration of their “BUY” rating.  Obviously they’re long the stock and want their buy rating to be heard in hopes of avoiding more of a sell-off.

The Formula For a Perfect Trade

When screening stocks for a potential 10% – 20% short-term gain, we want to ensure the following criteria are met:

  • Quality stock with moderate to high volume (Think GM, AAL, GOOG)
  • Major broker/financial group covering the stock
  • Stock has a Buy or Strong Buy Rating
  • Stock has a 12-month target price that is 35%+ higher than the current price

When To Make The Buy

If all of the criteria above are met, the next part of the formula is when should I make my trade and ow do I choose an entry point.  The key to remember is not to chase stocks.  If you miss your entry point, there will always be another opportunity.  That being said, when making trades like this, we want to:

  • Purchase the stock on a day the entire market is trading down.  Try get it on a 1% – 2% down day. These occur all the time.
  • Be Prepared to hold the stock for 9 months, although we may not need that long.
  • Don’t get emotional – when making a trade it’s all about numbers and profits.  We want to sell the stock when we get a 10% return.  You can wait if you think it’s going higher, but we don’t want to lose our gains. Remember the target price is a fictional number that most people are waiting for to sell – we want to realize our profits WAY before it hits this number and move on.