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Trading
Buy the rumour, sell the fact
Jeff Cartridge - November 7, 2007
 The cut in interest rates by the Federal Reserve last week in the US highlights the difficulty in trading news releases. The Dow Jones Industrial Index was up by 100 points prior to the announcement and in the next 20 minutes fell by over 100 points back to unchanged. Despite this rapid fall, or because of it, the market then rallied strongly - 20 minutes later it was higher than before the release. It shows that while news releases often lead to sharp price movements immediately after the announcement, the direction is not always clear. Sometimes "good news" can result in a share price falling while "bad news" can lead to sharp increases in the share price.
So why are news releases so important to stock market movements? The stock market is essentially a guessing game where all the participants attempt to guess what price to pay for a particular share. The trader’s guess may be based on short term price movements, while an investor’s guess may be based on a detailed financial analysis of the underlying company. It is extremely difficult to accurately determine the correct price for a company and if you asked 10 different analysts what a particular share "should be worth" you would get 10 different prices. It is this disagreement around the correct price for a share that is essential for the market to operate correctly.
If everyone knew that a share was worth $10, then it would rarely trade because no one would be willing to sell for less than $10 and no one would be willing to buy for more than $10. Fortunately this concept of perfect information does not exist. If I believe a share is worth $10 and you believe it is worth $8 we can create a deal that is beneficial for both of us. If we agree to trade the share at $9, you will get $1 more for the share than you think it is worth and I will pay $1 less. The future price movement will determine who made the better deal here, but at the time of the transaction we were both better off. It is the impact of this future movement that is the key when analysing news releases.
When a news release about a particular company is announced to the market it can change the perception of the value of the share. If a company announces that they have secured a large contract, this is likely to increase the perception of the value of the share. As the market participants review their valuation the share price is likely to make an adjustment in price, either higher or lower. The speed of this adjustment will vary, with day traders likely to be the first to react to the news, followed by those that follow the market on a daily basis and then by investors who monitor the market less frequently.
In the case of a company securing a new contract that will increase sales and profitability, the impact of the announcement is obvious. There are very few circumstances where this will not be beneficial for the company. But not all announcements are as easy to interpret. In the year 2000 Telstra announced the largest profit in Australian corporate history and the share price dropped, while a few weeks later Newscorp announced the largest loss in Australian corporate history and the share price jumped more than 10% for the day. To the new market participant this does not seem to make sense, but there is a sound basis for this reaction.
It comes down to the market participants’ expectation or perception of the value of the share. Neither of these announcements was unexpected, with most of the market expecting Telstra to announce a record profit and Newscorp to announce a record loss. When the Telstra report was released the profit reported was not as strong as expected, while Newscorp’s report contained unexpected signs of improvement. The stock market reaction is not determined by the news itself, but whether the news is better or worse than the market expected.
As humans we often prefer the anticipation of an event to the event itself. Have you ever been on holiday where the excitement builds long before you leave? Sometimes, the holiday is not as exciting as you imagined it could be. The anticipation was in fact better than the reality. In the stock market the same applies where the rumour is better than the fact. When it is rumoured that a mining exploration company has made a significant discovery; the size and extent of that discovery is unknown. The anticipation or speculation that surrounds the rumour can push a share price dramatically higher, but once the announcement is released the market participants all know the extent of the discovery and the reality of actually turning it into profit for the company. The reality is often not as good as the expectation. Consequently the share price falls once the news release finally hits the market. This phenomena has given rise to the well known market saying: buy the rumour, sell the fact.
Coming back to the Federal Reserve announcement: the market participants were expecting a rate cut of 0.25%, which is exactly what they got. The unexpected information in the result was the Federal Reserve’s warning around the risk of inflationary pressures. This wording indicates that future rate cuts are not guaranteed because interest rate cuts could add to the rising prices that are already being seen in oil, food and resources. The market reaction to this was immediately negative, with sharp drops in the Dow after the news release. This fall however was not sustained and the market rapidly rebounded, catching out many of the traders who had placed short positions and had to cover these positions quickly to avoid larger losses. Despite this strong rebound, the initial reaction of the market appears to be correct with the Dow falling over 350 points on Thursday night.
Trading news is not an easy thing to do. It is not just the interpretation of the news that has a marked impact on the share price - the expectation of the market must be taken into account as well. The expectation of the market is much harder to determine, though the initial reaction to a news release can give a clear indication of the future direction of the market. One thing for certain is that news releases can certainly increase the volatility in a share price and being aware of upcoming announcements will determine points that could be a catalyst for a change in price.
Jeff Cartridge is the author of Supercharge Your Trading with CFDs. For more information go to www.superchargedreturns.com.au. Please note that the views expressed here are those of the author, not of CompareShares. Although all investing has some form of risk, CFD trading strategies are only for experienced traders and risk management strategies must be considered.
More articles from this edition of CompareShares:
Economics: Wolf, wolf!
Economics: RBA to raise rates to 7.0% at one of the next two meetings
Rates: RBA ups interest rates to 11-year high
Rates: Households 'should rethink budgets'
Trading: Buy the rumour, sell the fact
Investing: Why investors shouldn't trust their own judgement
Forex: Hitchhiking on the carry trade
Commodities: Global commodities bull flexes its muscles
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