Through a glass rosily - John Daly

Meredith Whitney's "15 minutes" appear to be far from over. The CIBC World Markets banking analyst ascended to Wall Street's equivalent of Brad-and-Angelina megastardom last October when she downgraded her rating on beleaguered Citigroup Inc.'s shares and warned of a possible dividend cut. That triggered a $369-billion (all currency in U.S. dollars), one-day drop on U.S. stock markets already shaken by the subprime lending crisis.

And what's not to love? A smart, tough-talking blonde, married to former WWE wrestler John Charles Layfield (a.k.a. "Death Mask"), who--oh so rare among analysts--actually says what she thinks. "No one had the moxie to put in print what I put in print," she said.

Indeed, Whitney's pronouncements stand out because analysts rarely issue negative recommendations, and be-cause--so far, at least--she's been right. Although it shouldn't come as a surprise to any serious investor, analysts' buy recommendations still outnumber sells--or whatever euphemisms they use--by about 9 to 1.

Back in 2002, it looked like the profession might change, when then-New York attorney general Eliot Spitzer went after analysts hard. His whipping boy: Henry Blodget, star tech analyst at Merrill Lynch during the dot-com bubble (see "Look who's back," page 9). In 2003, 10 leading firms agreed to pay $1.4 billion to settle conflict-of-interest charges, and Blodget accepted a lifetime ban from the securities industry without admitting or denying civil fraud charges.

Yet, today, the scandal is water long under the bridge. Sure, Chinese walls are higher now than at the turn of the decade, but most analysts still wear soft gloves when it comes to the companies they cover. But the intriguing question isn't why analysts don't tell the literal truth; it's why retail investors continue to believe analysts' recommendations.

In a study published last August ("Are small investors naive about incentives?"), University of California assistant professor of economics Ulrike Malmendier and Harvard Business School assistant professor Devin Shanthikumar looked at analysts' recommendations from 1993 to 2002. What they discovered proves what we already guessed: Small traders tend to follow recommendations literally, exerting upward pressure on prices after "strong buy" and "buy" recommendations, and no pressure following "hold" recommendations.

But large traders are savvier. They tend to buy after strong buy recommendations, hold after buy, and sell after hold. Why is the split so clear? Malmendier and Shanthikumar couldn't find a definite explanation in the data, although they say the reason could be gullibility, er, "investor naivete."

It's doubtful such a study would produce different results if 2008 trading activity was used, especially in light of the upsurge in websites such as newratings.com that are dedicated to tracking analysts' upgrades and downgrades.

But reading analysts' reports isn't rocket science, or at least it shouldn't be. Just ask Blodget, who has risen from the ashes and now publishes the Silicon Alley Insider, a popular online newsletter that concentrates on tech investments.

So how should individual investors read these reports? "Almost all analysts are going to be flat-out wrong at least 40% of the time," says Blodget. "As long as you understand that, the reports are very reliable. I think the quality of Wall Street research has gone up in the past 10 years, but that doesn't mean analysts are right about stocks more often."

Nor should you take their recommendations literally. "The media generally equates buy ratings with 'urging investors to buy,' which is often unfair to analysts, because the ratings themselves aren't actually action recommendations," says Blodget. "I know that sounds ridiculous, but it's true. Most firms use the words as nouns instead of verbs, as in: 'It's a buy,' and not ' Quick, mortgage your house and buy!' "

Within constraints, analysts appear to choose their words very consistently. In a study entitled "Do security analysts speak in two tongues?" published last October, Malmendier and Shanthikumar found that analysts' buy and sell recommendations tend to be more optimistic than their detailed earnings forecasts. Why? The analysts know that retail in--vestors pay close attention to the recommendations, but bigger players concentrate on earnings.

Even so, analysts employed by underwriting brokerage firms tend to be more positive than independent analysts. Yet they often revise earnings forecasts down just before companies issue results--making it easier for the companies to meet, or even better, the Street's consensus earnings targets.

Again, Blodget isn't surprised. Picking stocks is just a small part of an analyst's job. That job also includes client visits, detailed financial analysis, primary customer research, historical research, meetings with management and investment conferences. "For most professional investors, stock ratings are the least valuable service that analysts provide, because opinions are a dime a dozen," he says.

Putting it in even more startling terms, Blodget isn't optimistic that retail investors have a hope when it comes to playing against Wall Street. "A Little League team is always going to get destroyed by the Yankees," he once told Bloomberg. "It doesn't matter what field they play on, and that is exactly what happens when individuals try to compete with hedge funds."

As long as the retail investor believes the analysts, then there's no reason to believe he isn't right.

WHEN BUY MEANS HOLD

Ever read the back of your analyst's report? While there's lots of dull fine print to help you fall asleep, one reason to read it is to see how your analyst arrives at making a recommendation. Not all "buy" and "sell" recommendations are created equal.

Canaccord Adams, for instance, rates stocks as "buy," "speculative buy," "hold" or "sell." The buy stocks are supposed to generate a return of more than 10% over the next 12 months, while the speculative buy stocks have a significantly higher risk. The hold stocks are meant to generate a return of 0% to 10%, while the sell stocks are expected to lose money.

Okay, that seems fairly straightforward, but what if two stocks that are both rated buy are forecast to generate returns of 11% and 50%, respectively? If what you want are bullish stocks, you'll have to pay more attention to the analyst's target prices.

The stock-picking system over at RBC Capital Markets is different than at Canaccord. RBC designates stocks as "top pick," "outperform," "sector perform" or "underperform" based on sector comparisons. Top picks represent an analyst's best bets, and can only comprise about 10% of his recommendations. Outperforms are expected to materially outperform the sector average over 12 months, while sector performs will be in line with the sector and, you guessed it, underperforms will underperform the sector.

If the sector is expected to underperform the market, then that outperform-rated stock in a lousy sector may suddenly look a lot less enticing.--Scott Adams

LOOK WHO'S BACK

In 1998, Henry Blodgetwas the boy-wonder analyst at Merrill Lynch who set a target price of $400 (all currency in U.S. dollars) for Amazon.com when it was trading at $242. After splitting, Amazon soared to the equivalent of $500. But four years later, he was the fall guy in Eliot Spitzer's offensive against tainted Wall Street analysts who had hyped stocks to help secure fat investment banking fees for their firms. No one received more scorn than Blodget, who was on record publicly recommending a stock like Excite@Home, while describing it in an e-mail to a colleague as "such a piece of crap!" By 2003, he had quit Merrill Lynch under a cloud and agreed to a lifetime ban from direct involvement in the securities business. Though only in his mid-30s, he appeared to be washed up. Notoriety often isn't fatal in America, however. Since his downfall, he's written an online column for Slate, and contributed to Fortune, Newsweek and The New York Times. Last July, he co-founded the Silicon Alley Insider, a New York City-based online news service that's garnered a big audience among do-it-yourself investors. In March, the website Wall Street 24/7 valued the Insider at $5.4 million, and ranked it No. 12 in its list of the "25 most valuable blogs," not far behind such Internet veterans as The Drudge Report (No. 8). Blodget is also a regular contributor to Yahoo! Finance's tech ticker, a news and video site.--J.D.