We all know what went wrong with Knight Capital Group Inc. (NYSE:KCG) last week. The big bug on the new trading platform inadvertently purchased stocks of many American corporations without any human input, resulting in the loss of $440 million within 45 minutes. The firm had to arrange emergency funding to keep its doors open; otherwise Knight Capital Group Inc. (NYSE:KCG) would have gone bankrupt. The market maker’s stock prices plunged over 75 percent within a day!
The irony is that almost all the sell side analysts had strong buy, buy and hold ratings for the Knight Capital stock. No, I am not saying that the analysts should have foreseen the technical error that occurred last Wednesday and changed their respective ratings. But what about those retail investors who followed the analysts’ ratings and put their hard-earned money in the KCG stock, and became penniless within a day!
The CEO of direct market access (DMA) vendor, Object Trading, said in a statement, “Machines only do what the human trading system developer tells it to do—which appears to be, in this case, to cross the spread. The issue is the fact that human direction errantly specified that be done, and the proper controls were not in place to stop it.” Then, how can sell side analysts so heavily rely on a new algorithm that hadn’t been tested in live trading conditions, to decide their ratings? This, when electronic trading already has a shameful past full of glitches. It is obvious in hindsight, but we have a point here.
A vendor official who has dealt with Knight Capital Group Inc. (NYSE:KCG) in the past, said that Knight Capital Group Inc. (NYSE:KCG) always develops its software internally, and he has always been skeptical of the market maker’s process of bringing the software up so quickly. He said that a haywire algorithm like this didn’t come to him as a surprise. So, should we say the vendor was much smarter than the highly qualified, research oriented and so-called expert analysts?
Lets see a bloomberg grab of analyst estimates of Knight Capital from just a few days ago.
The chart above clearly shows that 50 percent of analysts maintained a buy rating, and the other 50 percent recommended hold rating. The last stock price before the debacle was $10.33, and analysts had set a 12 month target price of $13.21, with an ROI of 27.92 percent. Anyway, as of 2 pm EDT today, the stock is trading at a miserable $3.19. Many analysts lowered their target exactly at the wrong time.
Well, here is the another example of their absurdity. After the KCG stock tumbled, CEO Thomas Joyce arranged emergency funding from a group of investors to keep the firm afloat. Now, when Knight Capital Group Inc. (NYSE:KCG) has pretty good chances of survival, many analysts have changed their ratings for the company to sell. The stocks are already down about 80 percent, and the company is on the path of recovery, so there are only chances of the prices going up. For example, today KCG reached a low of 20.07 and was trading as high as $3.18 today. Investors who bought at the bottom got a very nice return on their investment. But the sell side, downgraded the stock exactly when it was time to buy.
Then, does a sell rating really make sense?
The analysts should use more caution, especially when millions of dollars are at stake. What do you think?