How Can Investors Play the Calls?

The ultimate question is what does this practice mean and how can investors utilize this information? The answer is a psychological response, one that can only be explained by understanding how the market reacts to an analyst upgrade. We, as retail investors, take the advice of analysts and respond to their calls. Once an analyst initiates coverage with a “Buy’ or even an upgrade, it can create gains of anywhere between 3% and 10%. If you take a stock such as Sprint back in 2011, Facebook Inc (NASDAQ:FB) when it was below $20, or Apple Inc. (NASDAQ:AAPL) today, these are all oversold stocks. Therefore, an upgrade can spark a rally. If the rally continues we then begin to see the “follow-the-leader” reaction.

We have seen follow-the-leader analysis on both the upside and downside. We saw analysts downgrade Facebook Inc (NASDAQ:FB) while it was falling but then upgrade the stock as it has risen. In fact, analysts have been a primary contributor to the gains of Facebook Inc (NASDAQ:FB). Furthermore, we’ve seen it recently with Alcatel Lucent SA (ADR) (NYSE:ALU), Nokia Corporation (ADR) (NYSE:NOK), and Research In Motion Limited (USA) (NASDAQ:RIMM), but then as the stocks trend lower the outlooks change.

The bottom line: It only takes one analyst and slight gains to initiate this reaction. However, if a stock is trading lower or is at the bottom of its range, and is obviously undervalued, you won’t see these upgrades. As a result, I suggest waiting to buy stocks after that first upgrade following a series of downgrades. Of course the topic itself is very broad, which I explain here, but over the last year we have seen that this trend will produce large gains for investors who notice the trend and act.

Conclusion

The fact of the matter is that the “follow-the-leader” coverage will continue. The markets are too volatile, investment firms are too competitive, and no firm wants to take too large of risks. There is proof of this action scattered throughout the market. In the last day alone, Regions Financial Corporation (NYSE:RF) was downgraded twice after being upgraded continuously for the last year due to increased fundamental strength. Now, the stock might fall lower as the domino effect begins.

The best example comes from Facebook Inc (NASDAQ:FB), and BMO, as the firm downgraded the stock after issuing bullish notes following its earnings report. This is the same firm that had a “Sell” rating at $23 and then magically turned bullish with a “Buy” rating last month despite the stock being higher.  This doesn’t make sense but it occurs, as analysts either follow-the-leader or fall into the same mental traps that hurt retail investors. Either way, it can be damaging to invest against these calls while they are occurring but can be a blessing if you realize and purchase once the outlook begins to change.

The article Analysts Play Follow-the-Leader this Earnings Season originally appeared on Fool.com and is written by Brian Nichols.

Copyright © 1995 - 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.