This Wall Street Predictor Is Worse Than Your Weatherman

There's no doubt about the power of Wall Street analysts. Their estimates become the benchmark for company performance, sending a stock up or down when it beats or misses the Street's expectations. Upgrades and downgrades carry tremendous weight as well, and are often followed by respective fluctuations in share price. Powerful fund managers can make or break a stock's year with just a few brief words; take David Einhorn, whose questions on a recent earnings call prompted shares of Herbalife (NYSE: HLF) to fall more than 20% despite a strong quarter.

But of all the predictions and observations that come out of Wall Street, the most ridiculous has to be the one-year price target. This is the average price that analysts believe the stock will hit in the coming year. While having a price target to gauge a stock's performance might seem like a good idea, it belies the truth about investing. It's difficult enough to predict the direction of a stock, let alone its price. If it were that easy, we'd all just buy stocks with the greatest percentage growth in their price targets.

In an industry where the best stock pickers are right just 55%-60% of the time while dumb luck is 50/50, the obsession with predicting disguises the greater uncertainty in investing. Any number of macro or company-specific factors can take place in a year, spoiling a stock's chance at hitting its target. Andy Kessler, a former Wall Street analyst who wrote the book Wall Street Meat, called price targets "marketing fluff," explaining that they are used to drive sales calls, and are perpetually raised to create the appearance of growth, a phenomenon he called "target creep." In other words, it's easier to pitch a stock predicted to grow, say, 50% in the next year than one with a price target of zero growth. The targets create an ever-upward bias.

The fallacy of predictability
Based on the Dow Jones Industrial Average (INDEX: ^DJI) one-year price targets listed on Yahoo! Finance, analysts predict the index will gain over 16% in the next year. However, the average return of the Dow from 1975 to 2010 was only 9.3%, about half of what Wall Street is calling for, and the index has only gained that much in three years since 2000, two of which came after stock market crashes. The prediction, which would have the Dow hitting 14,500 within a year, seems especially optimistic considering the turmoil in Europe, the high unemployment rate in the U.S., and an anticipated slowdown in China's growth. Of the 30 stocks in the index, analysts believe that only AT&T (NYSE: T) and Verizon (NYSE: VZ) will go lower. The negative price targets are likely the result of the telecoms' strong performance over the last few months.

For more evidence of the lack of accountability in price targets, let's take a look at six predictions on various banks made on the stock valuation website ValuEngine.com last March.

Source: ValuEngine.com via Forbes.

As the chart above shows, four of the six predictions were nowhere near the mark, even though all the target prices were conservatively close to the then-prevailing price. And JPMorgan, one of the two predictions that were accurate, has since tanked after revelations of a multibillion-dollar trading loss.

Foolish takeaway
The examples above underscore how difficult it is to make accurate predictions in the stock markets. Weather forecasts offer a good comparison. They rely on modeling just like financial projections, but they only go out five or 10 days in advance because meteorologists can't accurately predict the weather after that. To give the high temperature for a year from now would be utter folly. Similarly, financial analysts have no idea what events will take place, macro or company-specific, to alter the value of a stock, nor can they predict the mood of market, which can affect stocks as much as fundamentals.

Perhaps there's no better cautionary tale than the story of Henry Blodget. Blodget famously put a price target of $400 on Amazon.com when it was trading for about half that in 1998, but the stock hit the target in just a few weeks and Blodget was rewarded with a job at Merrill Lynch. The stock picker's success turned into hubris, however, and he later lost $700,000 of his own money when the Internet bubble burst.

Anyone can be right once.

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