This morning, Netflix (NFLX) is up around two and a half percent in pre-market trading, and the main reason seems to be an upgrade of the stock by an analyst at UBS. That is good news for holders of the stock, but what does it really mean, and why is the stock higher?
If you follow the market and listen to financial news, you have certainly heard about upgrades and downgrades. The announcement usually goes something like “XYZ is trading higher today after being upgraded to overweight by Bank of Podunktown” or “ABC is lower after a downgrade to distinctly average by Irrelevant Bank” and sure enough, a glance at the ticker shows XYZ a few percent higher than the previous day’s close, or ABC dropping off a cliff.
These things are so frequent that we tend to take them for granted, but have you ever wondered why they have such an effect? They are, after all, just opinions, and who cares what somebody we have never heard of, from a bank we’ve never heard of, thinks?
Well, the people who care are financial advisors, and when a stock moves on an upgrade or downgrade it is a result of traders anticipating those advisors’ future actions.
For a couple of years, before corporate life got to me, I was an advisor for a major Wall Street firm. I went in with visions of using my dealing room background to help my clients understand the workings of financial markets, working with them to do our own research, then applying that knowledge to come up with some investment selections.
The problem was that that was in 2009/10, when the only people with less appetite for risk than my clients were the firm I worked for. Individual stock purchases were discouraged and could only be made in stocks with a positive rating from the company’s research department.
That may sound restrictive, but what I quickly came to understand was that it was a rule designed to protect me above all else. At that time, it seemed that every advisor you spoke to had at least one client who was attempting to sue them or the firm because the market went down. Unlike in most situations in life, “everybody thought it was a good idea at the time” was an effective defense in that situation, so thinking outside the box was considered a dangerous thing to do.
Things are not as bad now as they were then, but big banks’ legal departments have long memories, so advisors are still usually restricted to things with a decent rating from research. Thus, a change from “hold” to “buy” is not just one person’s opinion. It is also a buy signal for thousands of advisors who manage billions of dollars in clients’ funds, and usually triggers significant buying in the coming weeks. The initial pop in something like NFLX is therefore often just the beginning:
There are no guarantees in financial markets, and stocks reacting to ratings changes are no exception to that rule. But if you look at the upgrades to be found here, you will see that the majority of them have moved significantly higher since the change. When you look at the chart for NFLX above, therefore, and think that you missed out on the move up from the bottom, you should understand that probably isn’t true.
The upgrade by UBS caused traders to position themselves for buying that is yet to come, but come it will, and the stock is likely to continue moving higher for a while.