Stock downgrades refer to the reduced prospect of stock gaining returns in the market. Downgrades are announced by brokers or influential analysts who move their perception of stock from buy to hold, buy to sell, or hold to sell. It acts differently from a stock upgrade that views stock’s chances of gaining higher market returns.
After hearing this announcement, traders quickly move to sell the stock with the assumption that investors will dump or lower their investments. This drop mainly occurs when there is a downward breakout after the announcement. In such a scenario, there is a short-term market bearish continuation as the stock was on a downtrend before the announcement.
In an upward breakout, the price will rise for a short period after the announcement, most preferably, a week. This breakout initiates a short-term bullish reversal. The stock may be in an uptrend before the announcement. It may continue to rise for a week before the price is shot down as sellers exceed buyers in the market.
Identification of downgrade impact on stock
- Popular announcements
The trader must ensure that the trading expert announcing the downgrade is certified and works as a reputable brokerage firm. Announcements by major companies have a direct impact on the stock’s price. Traders must act quickly after establishing the authenticity and popularity of the announcing firm.
- View a large change in price
Traders will make more profits if they first observe intraday trading on the day of the announcement. If there is a large trading range on the day of the announcement, then the stock is likely to make a great price move. The trading range should be larger than the average price of the previous month before the downgrade announcement.
- Volume and breakout
Notice the downward breakout after the announcement. This breakout signals a downtrend, and the trader should prepare to sell the stock. In regards to the volume, there will be a surge in volume trends, especially if a major broker announces the downgrade.
Real market scenarios
Figure 1: Photronics Stock downgrade
Photronics Inc. (NASDAQ: PLAB) was downgraded by Stifel on February 25, 2021, when they lowered their rating from buy to hold. The investment analysis bank announced Photronics’ earnings-per-share (EPS) reduced from $0.16 to $0.13 (YoY). Additionally, the stock closed at $13.38 on that trading day declining 1.97% from the 52-week high of $13.65.
A look at figure 1 shows that the stock declined immediately from $13.21 on that trading day to $11.20 on March 8, 2021. PLAB stock declined 15.21% in less than 14 days after the downgrade announcement before it began picking up again. The trader that bought the stock immediately after the downgrade announcement would have lost up to 15% of his investment since the stock decreased in value. The number of sellers exceeded the number of buyers in the market.
Figure 2: Cimarex Energy
Cimarex Energy Co. (NYSE: XEC) was downgraded by MKM partners from buy to neutral on February 25, 2021. The research and trading company indicated that the fourth quarter (Q4) 2020 had seen the company lower the EPS by 24% from 1.18 in 2019 to 0.89 in 2020. XEC’s hit a 52-week high of 61.60 after plummeting to a year low of $12.15. The stock traded at $60.80 on February 24, 2020.
This stock downgrade did not negatively affect the price, as seen in figure 2. The price rose from $55.08 on the trading day to $69.31 (+25.83%). The stock only began to decrease from March 15, 2021, to March 25, 2021. The decrease could not be attributed to the stock downgrade.
In this scenario, an investor that would quickly rush to sell the XEC stock would burn his investment. The stock rose and was in an uptrend for close to 10 days after the announcement. The number of buyers exceeded the sellers in the market, forcing the price to shoot.
Figure 3: Viacomcbs Inc.
Viacomcbs Inc. (NASDAQ: VIAC) was downgraded by Moffett-Nathanson trading and research company on March 25, 2021, from neutral to sell rating. The broker decided to increase the EPS from $0.97 in Q4 2019 to $1.04 in Q4 2020 (+7.22%).
Additionally, the stock had gained 760.51% in the 52-week analysis from a low of $11.85 to a high of $101.97. However, the substance of the downgrade was derived from a decrease in the stock’s price as of March 24, 2021, which stood at $70.10.
The stock was still 31.25% short of reaching the 52-week high. Further movement of the stock’s price from the 52-week high led to the high impact of the stock downgrade to the stock’s price. Additionally, the stock’s rating shifted from neutral to sell, which denotes a drastic shift in the price trend.
So do you buy after a downgrade?
As revealed in the three examples, do not rush to buy a stock after a downgrade. The downgrade may push the price lower, but the price may continue the downtrend and bring about great losses. Look for reasons that may push the stock’s position. Fundamental analysis is crucial to initiate the trader’s decision.
Watch for the breakout to ensure the announcement was not made when the stock was close to a change in the trend line. Some downgrades occur when the stock is nearing its year low. Watch and ensure it bottoms before approving the buy signal.
In figure 2, the downgrade occurred after the stock had taken off from its yearly low and had already initiated a rounded bottom. The stock was bound to rise, and traders took advantage of the peak. If you have to short the stock in a downgrade, put a stop-loss to limit risk in case the market recovers.
Downward breakouts give the sell signal to the traders. Watch and begin to sell after a pullback (See figure 2). If there is an upward breakout, watch and ensure the price assumes a rounded position before selling.