One Of Wall Street's Dirty Little Secrets

January 31, 2023

There’s a dirty little secret on Wall Street.

One that’s counterintuitive for those on the “outside.” One that’s hard to wrap your head around. But once you do, you’ll become a much better trader.

Narrative drives price in the short/medium term. Not fundamentals.

You see, Wall Street makes money selling stocks to its clients. This is the “sell-side”.

It’s the reason why companies moved to quarterly earnings results and guidance in the late 90s.

Wall Street needed a reason to trade and sell more.

Here’s the findings of a 2006 McKinsey report regarding earnings guidance (emphasis added):

“Our analysis of the perceived benefits of issuing frequent earnings guidance found no evidence that it affects valuation multiples, improves shareholder returns, or reduces share price volatility. The only significant effect we observed is an increase in trading volumes when companies start issuing guidance—an effect that would interest short-term investors who trade on the news of such announcements but should be of little concern to most managers, except in companies with illiquid stocks. Our recent survey1 found, however, that providing quarterly guidance has real costs, chief among them the time senior management must spend preparing the reports and an excessive focus on short-term results...

Our conclusion: to maintain good communications with analysts and investors, companies that currently provide quarterly earnings guidance should shift their focus away from short-term performance and toward the drivers of long-term company health as well as their expectations of future business conditions and their long-range goals.2 Companies that don't currently issue guidance should avoid the temptation to start providing it and instead focus on disclosures about business fundamentals and long-range goals.”

The C-Suite of most publicly traded companies know Wall Street’s game.

It’s also a reason most of their compensation is tied to the share price and not the actual business performance of the company.

It becomes a reflexive loop.

Past examples were tech companies adding “.com” to their names during the late ‘90s. In 2020-2021, it was adding bitcoin to the balance sheet or “blockchain” to their names.

It’s all just narrative shifting.

Last year the narrative to bump one’s stock price was combating inflation.

Companies needed to prove they could navigate a high inflationary world to Wall St. More specifically, they needed to prove to Wall Street that profits wouldn’t suffer as costs continued to rise… aka how to maintain and/or increase profit margins.

The companies who led the profit margin narrative were those who had inelastic products or services. Ones who could raise prices on their customers: medical stocks, CPG brands, etc…

Think Johnson & Johnson, Kraft Heinz, Archer Daniels Midland and McDonald’s.

These companies outperformed the broader market in 2022.

But there are only so many price hikes you can pass onto your customers. After that, profit margins plateau.

(So far, these same companies are underperforming in 2023. The narrative has changed. Not their business economics.)

Tech companies’ products are more elastic. They couldn’t just increase the cost of whatever they were selling.

So instead they focused on cutting costs — i.e. firing employees. (We wrote about the increase in layoffs back in June.)

Wall Street rewarded early companies leading the mass layoff movement. Others not so much. It was dependent on the mood and sentiment of Wall St. at the time.

But now mass layoffs hit the wire pretty much every day.

Stocks aren’t moving as much anymore as a result. So management teams need to figure out what the new narrative is.

The narrative flavor of the day is artificial intelligence.

You’ve likely seen headlines about ChatGPT — an artificial learning model launched by OpenAI.

You can feed it any response whatsoever and the output is pretty incredible.

It’s become so powerful, it recently passed several graduate exams.

So companies are now looking to find ways to incorporate AI into their narratives.

Last week, digital media company, Buzzfeed, announced they would use ChatGPT to help generate content.

Its stock soared more than 300% the next day.

Chart

Buzzfeed was already a penny stock headed towards insolvency.

It needed a lifeline. It chose AI and it worked.

Whether or not AI will keep it solvent is irrelevant. Buzzfeed management likely already decided AI was its future months ago.

It tried the layoff narrative… as Buzzfeed announced two separate mass layoffs within the past 30-45 days. You can see its stock still couldn’t catch a bid. And went down to $0.75.

So you think a headline in the WSJ right after its stock went down was a coincidence?

Is it also a coincidence Microsoft doubled down on its investment last week as ChatGPT continued to go viral?

Microsoft first invested in OpenAI back in 2019. Hm…Why double down on it now?

Remember, Wall Street is in the business of making money. Nothing more. Nothing less. (See last week’s missive.)

So companies’ management teams looking to see their stock price go up hunt for the new narrative.

If you can identify companies looking to take advantage… then you stand to make a lot of money too.

Good investing,

Lance

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