Upgrade, downgrade, reiterate, initiate.The vocabulary of stock research analysts entered the vernacular of the late 1990s via televised financial news with the invasive force of a bad jingle you can't get out of your head. No sooner was the word "up" or "down" breathed over the airwaves did a stock move in the intended direction like notes in an capitalist arpeggio, as newly empowered private investors pressed the "buy" and "sell" keys of online brokerage accounts nationwide.

Now that the work of analysts is on the verge of being retroactively criminalized by the

Securities and Exchange Commission

and New York's attorney general, however, it's time to reveal the industry's dirtiest little secret. And it's not that brokerage analysts were on the take from investment bankers or the agents of Satan.

The real skinny is that virtually no one who matters in the investment industry -- which is to say, portfolio managers at large pension, mutual and hedge funds -- ever took nine-tenths of research reports seriously. Only the public did. As I explained in my book

Online Investing,

analysts at the major brokerages for years have been looked down upon by institutional investors as sales support staff, a pack of kids with fancy college degrees who provided little more than PR material for the retail brokerage and investment banking teams. If they were called "promoters" rather than "analysts," the public would have had a better idea of their role in the retail investment ecosystem. The funds have their own, unbiased, independent staff analysts.

Bear Market in Integrity

Bret Rekas, a hedge fund manager in Minneapolis whose youth included a stint as a technology analyst at Robertson Stephens, is one pro who can't understand why the government has only this year determined that the system was rigged against consumers. What'll they discover next? he wonders. That professional wrestling is fake? That recipes never turn out as good in your kitchen as they do in the color photos of a cookbook?

Rekas says that the real purpose of research on the Street has always been to provide a veneer of intellectual respectability to a sales endeavor that otherwise might not be considered much more lofty than the retailing of shoes, cars or potted plants. It probably won't sound like a great revelation now to contend that research reports still serve largely as patter for brokers hitting up retail clients on the phone for commissionable trades on shares their firms have in inventory, rather than serving as an exercise in fact-finding.

To a brokerage, a top-gun analyst isn't one with the most brains, but rather one who can both communicate a company's sex appeal to the sales staff and engender lust among the public in TV appearances. Publish or perish is the mandate in most research departments; the goal is to say something,

anything

, as often as possible to encourage consumers to ring the register by making a trade -- preferably on margin.

If brokerages no longer will be allowed to pay for their research staff with money made from investment banking, as the SEC proposed last week, then you have to wonder if any will keep their analysts. Because they are a cost center, not a moneymaker, it may ultimately make no sense for

Merrill Lynch

(MER)

or

Bear Stearns

(BSC)

to keep several hundred analysts on the dole.

Indeed, it could be a tremendous catalyst for the broken-down brokerage stocks if one of the top firms were to remorsefully announce it will pink-slip its whole profit-draining analyst crew. As it stands now, one industry expert has estimated that the investigation into Merrill's research misdeeds could cost the firm up to $2 billion -- $1 billion in settlement fees, lost business of $500 million and civil damages of $420 million. That would far surpass the $600 million tab that killed off Drexel Burnham Lambert following junk-bond investigations in the late 1980s.

What would be lost except for the stain of lies? Certainly little of value. One of the reasons the market has not responded to an up tick in the economy as heartily as I had expected is that there is a bear market in integrity. If stock consumers can't find help in discriminating between the good and the damned, it's natural that they would simply abstain. In the absence of Merrill or Bear Stearns analysts, the slack would be taken up by independent Wall Street firms whose analysts are respected for their brainpower, not just good looks and writing styles.

Companies such as Sanford Bernstein, whose researchers are typically the first ones mentioned by fund managers when asked for a credible source of stock analysis. Or Investment Strategy and Investment Group

ISI, whose daily economic reports are considered by many pros one of their few must-reads every morning. Or CreditSights, which provides excellent independent corporate and sovereign debt research.

David Hendler, a former Credit Suisse First Boston equities analyst who now covers financial companies at CreditSights, said that the best analysts at brokerages "will get sick of the game." Fed up at the lack of support from their managers against the corrupt demands of investment bankers and sales staff, they will leave and form their own research shops. The result could be a return to the 1960s and '70s, when boutique research firms flourished.

"If you don't pay for your research, you won't get unbiased research," Hendler said. "If you want good ideas, you've got to pay for them."

Stacks of Unread Reports

To learn what the pros think of most brokerage research, just visit the office of one and look for the inevitable tall stack of research reports. Chances are it is not on the fund manager's desk, ready to be consumed with interest like the sports page or a new gourmet joint's take-out menu. It will be next to the wastepaper basket.

When I visited the co-manager of a $10 billion trust fund in Manhattan on a recent Friday afternoon, I asked whether the knee-high pile of reports constituted just the rejects from the past week. "God no," she said. "That's everything I got today -- you can't get them to stop sending this crap. It's like spam." An ISI report, in contrast, was on her blotter, with yellow highlights and notations in the margins.

Likewise, the manager of a major hedge fund told me this week that he primarily uses Wall Street research reports to determine the consensus view on any given subject, because the analyst system rewards conformity, not independence. He also stacks them up in his office, unread, in piles by subject. The more paper a single topic generates, the more interested he becomes in betting against it.

I have abstained from quoting brokerage analysts for at least a year, though I will interview independent specialists to get up to speed quickly on an industry, such as defense-industry expert Paul Nisbet at JSA Research.

But Rekas scoffed at my cynical suggestion that fund managers and analysts might have colluded in the past to pump and dump stocks. Instead, he said, they are competitors in a high-stakes game in which analysts, and ultimately consumers, were played for suckers.

Here's an example: Rekas said an analyst might visit a big fund firm such as

Fidelity

or

Putnam

and pound the table on a stock his firm is trying to flog. If the fund manager wanted to sell a big position in that same stock, he or she might encourage the analyst, creating a positive feedback loop. "Then what does the Fidelity fund manager do when the analyst goes back to his office and publishes a report upgrading the stock?" Rekas asks rhetorically. "Of course, he sells into the euphoria. Nothing illegal there. It's a poker game, and the manager is looking out for his own best interests."

What's to Like?

So what does the renegade ex-analyst like these days himself? Rekas' fund, Lakeside Bull and Bear, specializes in a market-neutral strategy of being short as many technology stocks as it is long. He's not particularly bullish on any tech stocks, sensing that they could potentially be out of favor through the rest of the decade, but as long as he has to be long something, he likes

Sun Microsystems

(SUNW) - Get Report

and

Oracle

(ORCL) - Get Report

in the single digits.

"Unless you think there is going to be an extinction-level event and Sun is going away, at six bucks I'm comfortable buying it now," he says, contending that the company has deep management that can survive the recent loss of a couple of top executives, a ton of cash, not much debt and a lock on the high-end UNIX workstation business.

Rekas doesn't buy the current argument that

Hewlett-Packard

(HPQ) - Get Report

is eating Sun's lunch in the high-end server business, and he doesn't think low-end servers running

Intel

(INTC) - Get Report

chips and

Microsoft

(MSFT) - Get Report

software pose a serious threat on the low end either. Rekas is not expecting the stock to go from $6 to $12 overnight, however, adding with a guilty laugh: "I'd be happy to see it go from $6 to $9 in the next 18 months."

He doesn't care much for networking equipment stocks such as

Cisco Systems

(CSCO) - Get Report

, but at $8 considers enterprise software-maker Oracle a reasonable gamble. "It's like Sun -- I'm not falling in love, but I think they'll survive. They may not be a great growth company for the next few years, but a lot of the risk of extinction has been ground away at this level."

Survival may truly be the name of the game for investors now as they recover from a painful bout of cynicism. Brokerages could hasten the recovery by cleaning house before government bureaucrats or lawmakers do it for them. Until then, it's best to pick targets carefully, focusing on companies, as Rekas does, with little debt, prices under $10 but above $5, and annuitylike streams of quarterly revenue from established businesses in little danger of vanishing overnight. I've already got Sun in the SuperModels portfolio at $8.10, but I'll add Oracle if it retreats to the $7.50 area.

At the time of publication, Jon Markman owned or controlled shares in none of the equities mentioned in this column.

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