The Stock Market’s Reaction to Good News
The Smart Profits Report: Traders’ Tuesday: Issue #335
Tuesday, July 25, 2006
The Stock Market’s Reaction to Good News: Why It’s Best to Sell at the Sound of the Trumpets
By D.R. Barton, Jr.
Advisory Panelist, Mt. Vernon Research
Some pundits and investors are salivating… They believe that good news on one or both of a couple key looming events will be enough to send the market soaring skyward.
But watch out. History tells a different story.
Indeed, history has proven over and over again that the stock market’s reaction to good news is highly temperamental, and it often reacts negatively. But why? What causes such unpredictable behavior? We’ll look at why this happens and what we can expect in the coming days and weeks.
First, let’s take a look at the two factors that have some folks fooled…
Don’t Fall for These Two “Good News” Myths
First, you’ve got the hostilities between Israel and Hezbollah. Many are worried that the fighting could escalate and spill over into other countries in the Middle East. But others hope for a cease-fire and further hope that an end to the hostilities could be the catalyst the market needs to send it skyward. Don’t count on it.
As Lord Rothschild said (paraphrased): “Buy on the sound of the war-cannons; sell on the sound of the victory trumpets.” You would do well to heed this legendary speculator’s contrarian advice.
The second piece of potential good news on everyone’s radar screen is that the Federal Reserve has recently dropped not-so-subtle hints that that it will finally take a rest from its incessant rate hikes. Everyone expects that when the Fed stops tightening, the market will spread its wings and fly. Once again, don’t be surprised when the good news myth gets busted.
But some investors do get fooled every time. The anticipation of market-moving news gets them excited, but is soon punctured shortly thereafter with lots of disappointment. This pattern repeats itself over and over.
Here’s why you should pay attention to Lord Rothschild’s savvy piece of contrarian advice when he suggested that the best play is to not get overly optimistic about good news at the end of a conflict…
Sell on the Sound of the Victory Trumpets
It’s useful to understand the market this way: It acts as a round-the-clock valuation mechanism. It constantly asks the question, “What is the value of Event X in the future?” And it immediately answers that question in the form of a price.
The event in question may be a company’s earning report. The market would ask:
- What is the likelihood that the company will exceed its earnings projections?
- What is the likelihood that it will underperform?
- What would either of those events mean in terms of the stock price?
As you see so often, with every little hint of better performance, stock prices jump. And with any suggestion of a letdown, prices drop. All of this happens on rumors and inference.
The end result? By the time earnings are actually announced, the stock market has already digested almost all the possible information about the earnings announcement and valued the stock accordingly. So the only way the stock’s price will move significantly is if there is a surprise.
Then there is the “myth of good news” - another factor that often shocks people. For example, the stock’s earnings report is released, showing that the company met expectations, earning five cents a share. The public thinks this is good news and expects the stock to rise. But in a pattern we see over and over again, the stock may move up for a short while, only to start dropping, despite the good news. Why?
Because the news was already calculated into the price by the markets valuation mechanism.
The good earnings were expected. The price had already been adjusted to take those earnings into account. And when the company announced that expectations were met, there was no new good news. So any chance for even better news is lost and the price trickles lower.
The Key to Understanding The Stock Market’s Reaction to Good News
So next time good news hits the stock market and the share price still goes down (usually after a very short spike up), you’ll know why.
Here’s the key: If the stock market has already anticipated good news, the actual news will have little effect on prices, or will even have a negative effect. To clarify this, let’s look at a couple of examples:
- End of War: The classic example comes following the cease-fire in the Vietnam conflict. After prices spiked briefly, they headed down. While the ceasefire was good news, it was expected. Lord Rothschild’s advice was spot-on again…
- End of Federal Reserve Tightening: Jason Goepfert, the excellent sentiment analyst, has conducted some compelling historical research on what happens after the Fed stops raising interest rates. In the six months after the end of a tightening cycle, there is strong support that shows stock prices dropping. So be aware that one of this year’s most anticipated events (the end of the Fed’s interest rate hikes) may bring more disappointment than expected.
Here’s what you need to remember: While you might expect that the stock market’s reaction to good news would be to soar skyward, if that news was expected, the euphoria is usually short lived and brings only a temporary spike to the market and prices. So don’t get caught up in the emotions of the moment when the good news - which everyone was expecting - finally comes.
Good Trading,
D.R. Barton Jr.
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Today’s Smart Profits Cribsheet
- With so many forces at work these days, it’s hardly surprising that the market is experiencing one of its most volatile periods. But you don’t have to sit back, watching and wondering. Learn how you can use volatility to your own advantage in Smart Profits #321, Fast and Furious Volatility is Back in a Big Way: How To Profit Using Leg Spreads & The VIX. 062206
- As always, don’t forget to visit the Smart Profits Glossary for definitions of options & market terminology.
Related Articles:
- Event-Driven Markets: The ONE Case for Using Short-Term Options
- Timing Your Trades: Two Ways to Expand Your Thinking
- The Future of Crude Oil Prices: How a New Saudi Development is Bearish for Oil Prices
The Chart of the Week
This chart of Ruby Tuesday (Nasdaq: RI) shows how it was a victim of the good news myth.
On the evening of July 11, RI announced good earnings. The next morning it opened up strongly, traded up briefly and then sold off the rest of the day. Since then, it has dropped more than 12%.
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