What You Can Learn From How The Market Reacts To News

December 5, 2017

What You Can Learn From How The Market Reacts To News

  • I’ll analyze a few scientific studies on how news impacts stock prices and also a couple of interesting case studies.
  • There are some rules that can be applied to news and stocks.
  • It’s interesting how Wall Street always weighs the short term much more heavily than the long term.



Introduction

I’m sure you often see abrupt price moves with the stocks you follow or own. Those abrupt moves—which can go to 10% or even 20% in a day for a relatively stable business, 20% to 50% for a mining company, and even more than 50% for a pharmaceutical—are due to some kind of news coming from the company or related to the company that makes investors take action and sell or buy.

Today, we’re going to discuss how stocks usually react to news, the information asymmetry, the stock price drift, and how to take advantage of the sharp price moves.

The iPhone Release Of 2007

When Steve Jobs announced the first generation of the iPhone, saying the “iPhone is a revolutionary and magical product that is literally five years ahead of any other mobile phone” on January 9 2007, Apple’s stock price immediately jumped from $12.21 to $13.22, and then to $13.87 five days later. And yes, Apple’s (NASDAQ: AAPL) stock was trading low just 10 years ago.

Figure 1: AAPL vs. the S&P 500 10 days from the iPhone release in 2007. Source: Yahoo Finance.

What’s interesting is that after the initial enthusiasm, AAPL’s stock quickly went back below $13 and actually underperformed the S&P 500 over the 10 days after the iPhone announcement.

The rest is history, but it’s good to remind ourselves of how AAPL outperformed the S&P 500 and those who understood the revolution announced on January 9, 2007 have really enjoyed an amazing run.

Figure 2: AAPL vs. the S&P 500 since the iPhone release. Source: Yahoo Finance.

The interesting thing to learn from the AAPL story is that there is a big difference between how Wall Street weighs the news and the actual importance of the news. AAPL’s story shows that in 2007, very few understood what AAPL was doing and how it would actually change the world. In fact, at the time, investors were more interested in investing in the general market than in AAPL as the stock underperformed the market in the subsequent 10 days.



What’s interesting, and what has also been confirmed by academic studies, is that after the announcement of significant news—which a listed company is obligated to make thanks to the Regulation Fair Disclosure Act from October 2000 and of the Sarbanes-Oxley Act from July 2002—the volatility of the stock increases, just as the case was with AAPL. The increased volatility means that investors don’t really know how to adjust their models to the new information and many can’t do it quickly. This creates a lot of information asymmetries in financial markets from various research power and industry knowledge to quickly interpret the information to different investing goals market participants have. For investors, the increase in volatility means that there is time to assess the news and make proper investing decisions as it’s highly probable that the stock price will come close to returning to its price before the release of the news.

A funny note here. According to scientists from Georgia Tech, the reaction to unscheduled market news in December is much smaller than in other months which indicates that many investors have their mind elsewhere, further increasing the information asymmetry.

Apart from the December doldrums, Wesley Chan, in his Journal of Finance article, described that there is a strong drift after bad news as investors tend to react slowly to bad information, especially with less liquid stocks. This could easily be explained by loss aversion. An investor hopes that the bad news won’t have a significant impact on the stock and therefore does not sell immediately, however as the stock price starts falling, many rush to sell in order to avoid further losses. This creates an opportunity for those who are quick to assess the new information as they can sell immediately after the bad news has been made public.

From that theory we can deduce that if you can sell in the first minutes after the bad news has been released, you should do so, especially with less liquid stocks as those stocks are less covered and it takes some time for everyone to digest the situation. Additionally, as was the case for AAPL, there is also plenty of time to take advantage of long term positive news as Wall Street is mostly focused on short term issues and not so much on the long term.

An interesting situation happened last week with the stock of Lundin Mining (TSX: LUN, OTCPK: LUNMF) and is a great example of short term vs. long term Wall Street orientation and how investors can take advantage of it.

A Recent Example Of How The Market Reacts To News – Lundin Mining

Lundin Mining (TSX: LUN, OTCPK: LUNMF) announced an updated operational outlook on November 29, 2017 after trading hours.

To summarize the report, LUN is going to be making significant investments in both the mine and the mill at Candelaria to increase the copper production profile over the life-of-mine. The focus will be on improvements in 2021 and beyond, while the forecasts for 2018 and 2019 were lowered from their previous outlook under the new re-phased open pit life-of-mine plan, which will address localized pit wall instability, reflecting the short-term impact on production from a recent slide.

What we have here is a company that has said it will increase overall production and focus on the long term because that’s something that will best increase shareholder value. What happened to the stock price on this news? It dropped significantly.

Figure 3: LUN’s stock price the week of the announcement. Source: CNN Money.



What’s interesting is that the stock price fell to $5.52, bounced back to $5.9, and has stabilized around $5.72. My point is that it’s impossible to precisely estimate that the new updates created a decline in value of $1.3 per share, as it’s really impossible to estimate what will happen. Nevertheless, it’s clear that the market didn’t like a 20% decrease in production for 2018 and 2019 and didn’t see the 20% increase in production from 2021 onward as a sufficient counter value. However, increased production should also mean increased revenue and profits over the long term which makes this stock price reaction a positive for long term investors that accumulate businesses, and a negative for short term speculators.

Conclusion

We can conclude that illiquid stocks tend to adjust slowly to negative news while short term negative news weighs much more heavily than long term positive news as the long term brings to mind more uncertainties. Nevertheless, short term bad news or weak reactions to potentially disruptive technologies, as was the case with Apple, should be something for investors to take advantage of.

© 2017 Investiv

By Sven Carlin Apple Investing Strategy Investiv Daily Share: