Why I Don't Trust Price Targets
A static target in a dynamic environment is illogical, but it creates an illusion of precision and certainty.
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Wall Street loves price targets. In theory, price targets remove all the hard work of investing. All you need to do is buy a stock with a significant price target, then sit and wait. When it hits the target price, you lock in your huge profit and move on to the next stock with a huge price target. It makes the whole investment process very simple and easy.
Of course, it isn't that simple. Price targets are manifestations of hopes and dreams. They are based on a host of assumptions that change daily, but little is appreciated about how small changes in fundamentals can have a giant impact on a price target.
There are two basic types of price targets. The first is based on fundamental analysis. An analyst prepares a spreadsheet predicting future revenues, expenses and earnings and then discounts that to present value using the appropriate interest rate. They then assigns a PE ratio to that number and arrive at a price target. It looks very precise, but much of this data, like the discount rate, is very subjective, and small changes in interest rates can have a significant impact. No one knows what the future data will be, but the process adds an aura of certainty and gives the market a hard number to contemplate. That target price will ultimately be used to determine whether the stock is a good value.
The primary problem with price targets is that they are an excuse to be lazy. Why even bother to watch a stock if you have confidence that your price target will eventually be attained? Targets would be an extremely simple way to passively make money — if the targets actually work.
Price targets are static numbers in a dynamic situation. They fail to take into account that conditions are constantly changing. A price target set today might make sense, but if a war occurs, a pandemic hits, interest rates rise or the economy shifts, then it will look downright foolish tomorrow.
If analysts were good at setting price targets, that would suggest that they could effectively predict market tops. When the market is extremely extended, then nearly every stock would be trading above its "target" price, and it would be clear that stocks need to correct. The reality is just the opposite. As a stock rises in price, analysts keep finding ways to increase targets. They can be very creative at finding ways to keep moving targets higher and higher.
A good recent example of how price targets are used by analysts in an illogical way can be seen in Apple AAPL. There have been a number of large target increases in recent months based on the argument that Apple is about to roll out significant AI-related products. Estimates haven't gone up much, but the multiples have, and that is all that is needed to increase a target. Back in the internet bubble days, there was a similar process where target prices were justified using metrics like pageviews and other things that had questionable predictive value.
The second type of price targets are those set by technical traders, and they aren't any better. One of the favorite approaches is the "measured move." This is just an extrapolation using past action. It is based on the idea that a stock that moved X amount off of a base in the past is likely to see another move of the same proportion in the future. It appeals to a sense of order and logic, but there is no reason that stock should move in this fashion and, in the vast majority of cases, they never act in the way predicted. Sometimes traders make targets a self-fulling prophecy in the short term, but generally, it is just wishful thinking.
The great value of price targets for traders is that they can create short-term movement. It can be very lucrative to trade aggressive analyst price targets that create an emotional response.
Price targets do influence psychology even when the calculations are subjective and questionable. A sudden large increase in a price target will lead market players to believe that there has been a significant change in a company's business, and that can help create some sustained momentum that makes for good trading. Sometimes, that is true, and the price target increase will be the start of a major run.
I am asked all the time what my price action is for a particular stock that I like. My answer is that I don't have one. My experience is that stocks with momentum will almost always go higher or lower, far more than seems reasonable or logical. The only way to trade them is to watch the price action and react when it shifts. A price target isn't going to help with that process and may actually inhibit it if given too much weight.
Price targets are rarely accurate, but they are accepted by the market as having some value, and they do exert an influence at times. They can help create some good trading opportunities, but don't take them too seriously. They are just a function of hopes and dreams and will shift on a daily basis. Focus on the price action and the fundamentals, not a random price target.
At the time of publication, DePorre had no positions in any securities mentioned.
