CHAPEL HILL, N.C. (MarketWatch) — Things could get worse for Facebook’s stock.
That’s saying something, given that Facebook FB, -18.75% has already taken a huge hit. In the wake of its disappointing earnings report Wednesday after the stock market closed, the company’s stock is down about 20% Thursday.
I’m not making this prediction because I have inside information about Facebook. I am basing it on academic research into how bad news about a company eventually gets incorporated into its stock price. In the face of bad news, Wall Street analysts are famously slow to react. Facebook’s price is therefore likely to fall even further as analysts gradually incorporate the bad news into their analyses and lower their target prices.
Read: Facebook’s downbeat forecast leaves most analysts miffed at Zuckerberg
Slow reactionWhy are analysts slow to react? Researchers have identified several reasons:
• Forecasting is an inexact science, at best, and analysts never possess enough data to make more than an educated guess. Analysts, therefore, tend to be conservative, often waiting until the data point overwhelmingly in a different direction before fully updating their forecasts.
• Analysts don’t want to appear that they’re following the consensus. Imagine, for sake of illustration, the 17 Facebook analysts (of the 44 that FactSet includes in calculating analysts’ consensus) who have yet to downgrade their forecasts in the wake of the company’s earnings announcement. Let’s say one of those 17 is now convinced that the consensus is right. He will face incentives to resist the appearance that he’s following the herd instinct, and instead show his clients that he thinks for himself.
• Analysts don’t like to alienate company management. They depend on the relationships they have with executives for information and access, after all, so they don’t like to endanger those relationships. This can be particularly true when a stock is as widely held as Facebook, since analysts don’t want to upset their firms’ institutional clients who own large positions in the stock.
As a result, according to Michael Clement, an accounting professor at the University of Texas at Austin, the market tends to react more quickly to bad news than do the analysts themselves. To put it another way, analysts more often than not follow the market rather than lead it. In an email, he referred me to one famous study that found that analysts’ forecasts typically reflect only 66% of the information that the market itself has already taken into account.
That would be of little more than academic interest if analysts’ underreaction didn’t itself affect the market. But it does: When analysts do eventually get around to fully incorporating new information in their forecasts, their downgrades cause stock prices to drop even further.
Downward spiralOne not-unlikely consequence is a downward spiral: First, the market reacts relatively quickly to unfavorable news about a company; second, that is followed by downward revisions from analysts; and third, it in turn leads to even further declines in the company’s stock.
One thing that this body of research doesn’t help us determine is how far Facebook’s stock will drop. But, as you can see from the accompanying chart, Facebook dropped by more than 20% earlier this year, following two months at the end of 2017 in which the share of analysts downgrading the stock rose to just 25%. So far in the wake of the company’s latest earnings disappointment, in contrast, that percentage has risen 61%.
Contrarians who like to buy when the blood is running in the streets might therefore want to wait a while longer before stepping up to the plate to invest.
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email mark@hulbertratings.com.
