What Can Go Wrong? Everything, Part 1

Editor's note: In this multipart series, Jim Cramer will tell you everything that can go wrong with a stock. The trader believes that the post-April market has brought about new soberness and investors need to change their approach.

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Too many people just don't get it: Most of the time stocks go down. Sure, there have been an immense number of winners during this great bull market that began 18 years ago. But there have been far more losers. People constantly ask how we are successful at Cramer Berkowitz, and I always say the same two words: Loss Avoidance.

We seek to sell the stocks that could cause grave capital losses. Many of you believe that when your stocks go down it is a conspiracy of insiders fleeing, big boys getting out ahead of you and analysts conspiring with short sellers.

Wrong!

Most stocks go down because they were meant to go down. They went down because something went wrong. What could go wrong? Ah ha, you have come to the right place. In this multipart series I will try to tell you everything that can go wrong with a stock. It will be a virtual catalog and I want you to save it so that when something like this happens to your stock you will know what to expect and who to blame. It's all part of my belief that the post-April market has brought about new soberness and we need new sober investors to go with it.

I will cover things that can go wrong from all different industries, not just tech, and I will try to place emphasis on what I think is important or unimportant. I will analyze the psychology of Wall Street and get you in the heads of portfolio managers like me and what we think when we hear about problems. As with everything I write, I will try to write it without the sugar, you don't need to hear what you may already know. There are villains and good guys out there, no doubt about it, and I will call 'em as I see 'em.

Analyst Downgrade

Let's start with the most elemental: an analyst downgrade from buy to hold. Why does this matter? Let's look at a recent downgrade by Jon Joseph of the semiconductor group at Salomon Smith Barney, which included specific stocks, such as downgrades of National Semi (NSM:NYSE - news - boards) and Texas Instrument (TXN:NYSE - news - boards).

First, why should we care? I will tell you why. When I worked at Goldman Sachs, I was looking for commissions and I was looking to make money for my clients. Those are natural tensions and sometimes they are in sync. I admit that if I were at Salomon this downgrade would have been big news for me. I would have gotten on the phone to my biggest clients and said "Joseph's taking off the semis. He thinks pricing has peaked. It is an impact call."

Now, let's take apart this downgrade to see how serious it really is. The first thing I look for in a downgrade is an earnings cut. If numbers are coming down, that's a huge red flag for us. In this particular case there were no numbers cuts. But had there been, we would have immediately checked around, including with First Call/Thomson Financial, but more likely asking our individual brokers, "What were you looking for next quarter and next year."

Let's say Joseph had downgraded National Gift Wrap and Semiconductor. We would call 10 firms and say, "What are you using for National Gift next year?" That's short hand for, "What is your analyst carrying for earnings estimates for National Gift?" Let's say everyone was clustered at $5 and Joseph went to $4. That could mean look out below. But let's say everybody was clustered at $5 and Joseph had been at $5.35 and he was just "getting in line," meaning he was just adjusting his numbers down to where everybody else is. That's not much of an impact call. If the stock gets hit, I want to buy it. And if he did no number cuts, "numbers unch'd" and the stocks get hit, that's probably a buying opportunity because the next day you can bet that the stocks' adherents will "reit buys" or reiterate their buys and try to move the stocks back up.

Specific Downgrades

How about a specific downgrade of a specific stock? Again, if there are number cuts, we take notice. Otherwise, it may be a "strategy downgrade" which we don't really care about. A lot of firms make committee decisions about buys. A strategy downgrade, one where the top-down guru at the firm reweights a stock or takes a stock on or off some firm's recommended list means little to us. We care, again, only when there is estimate guidance that brings the firm to below the consensus.

We get really nervous, though, when an analyst takes his numbers to the "lowest on the Street" in a downgrade. That often indicates to us that the analyst has found out something specifically worrisome about a company and is signaling, through the downgrade and through the numbers, that things have turned bad. If we "catch a downgrade," meaning if an analyst downgrades our stock, we probably will sell it, no matter what, if we see that numbers have gone to the low end of the Street, because that often signals that a company is about to preannounce bad earnings or that the company itself called around to select analysts and let them know that their numbers are too high. (Estimates they are carrying can't be met.)

Just Plain Wrong

Many of you think that this kind of dissemination is just plain wrong. You want to hear it from the companies themselves. Some of you are online traders not covered by these firms and you think it is unfair that they have any information that can impact your stocks. All information that can move your stocks should be from the company. That's just hogwash and you have to come to terms with the way Wall Street works.

Wall Street is a promotion machine. Its analysts try to find out things about companies and downgrade and upgrade them to move them. If they can move them then the sales force will get behind them. If the sales force gets behind a powerful analyst who has gone from positive to negative with a number cut that takes him to the low end of the Street, you are history. That stock is going to get clocked.

I used to play this impact game to the hilt as a salesman. When one of Goldman's great guns, a guy like Dan Benton, who now runs a giant hedge fund, went out negative on a Dell (DELL:Nasdaq - news - boards), say, and cut his numbers, I would call everybody and his brother to get them out of Dell. It would be my mission. That was massive impact. It was, in the words of my old boss, "proprietary" and you had to do everything in your power to get that news to your client before it hit the "Dow Jones tape," or the newswires.

Nowadays brokers live in fear that their clients will hear about important downgrades from CNBC first. That's no good and shows the broker up. It is devastating when you, as a client, hear things first from Maria Bartiromo and you don't want that happening.

So, to recap, a downgrade with a number cut to below the Street's lowest earnings estimate is the worst thing an analyst can do to a stock. A downgrade from the "axe," the really powerful analyst from a major firm, will mean delayed openings, losses and ultimately a really poor day for a stock.

Just so you know what I am talking about, let's say Mark Edelstone , TSC's top-ranked analyst, tomorrow goes out and says that Intel (INTC:Nasdaq - news - boards), which he thought was going to earn $2, is only going to earn $1.80 so he is taking the stock from a buy to a hold. If the lowest estimate on the Street before this was $1.90, you might want to sell your Intel. Even if you love Intel.

If Joe Blow strategist takes Intel off the firm's buy list but the analyst doesn't touch his own recommended list (often these are separate lists), I pay little attention. That may have more to do with some sort of macro equation, maybe the strategist thinks the economy is slowing and chip stocks will get hurt. That's a nonevent for us.

Other Types of Downgrades

What other type of downgrades are there? There are technical downgrades. I find these to be totally useless. A Smith Barney technical downgrade of a stock means nothing. It just says the stock has been doggy lately. I simply don't care about it.

A powerful, negative brew gets concocted when Maria Bartiromo gets hold of a downgrade, no matter what kind. She rarely has the elegance or time to understand the nature of the downgrade. Recently her repeating of some negative comments about EMC (EMC:NYSE - news - boards) from a firm got translated into something much bigger than it really was. We gave it wide berth and then we bought. Like her or not, Bartiromo is very powerful. And a point decline without her gets translated to a delayed and dislocated opening if she really rams it home.

Check back tomorrow for Part 2.

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James J. Cramer is manager of a hedge fund and co-founder of TheStreet.com. At time of publication, his fund was long EMC and Intel calls. His fund often buys and sells securities that are the subject of his columns, both before and after the columns are published, and the positions that his fund takes may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Cramer's writings provide insights into the dynamics of money management and are not a solicitation for transactions. While he cannot provide investment advice or recommendations, he invites you to comment on his column at [e-mail].