Why news matters
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News can have a profound impact on financial markets, whether it’s a groundbreaking innovation with the potential to skyrocket a company’s profits or a new regulation that could severely impact an industry. However, the influence of breaking news on market prices can be complex and not always straightforward.
There are two main categories of financial news: anticipated news and unexpected news. Both types have distinct effects on market prices. Unexpected news is often the most memorable, consisting of sudden, unforeseen events like CEO resignations, cybersecurity breaches, or leaked scandals. These events can trigger rapid and significant market movements, causing prices to either plummet or soar in an instant.
On the other hand, anticipated news, such as earnings reports and interest rate decisions, doesn’t always lead to immediate shifts in market prices. But this doesn’t make them any less relevant.
Financial markets are more nuanced than it may appear at first glance, and understanding why some news doesn’t trigger immediate price changes is crucial.
Why does this matter? Because news, in all its forms, exerts a massive influence on markets. Even if you’re not an active trader, you need to at least understand why those movements are happening (or, not happening). The fluctuations are bound to impact your investments one way or another.
If you’re considering actively “trading the news”, it can be a viable strategy, but it comes with fierce competition, as we’ll explore later. So, grab your news sources, tune in to broadcasts, and prepare for the frenzy of the newsroom.
But first, let’s delve into why certain news may not impact asset values.
Efficient markets and the concept of “Pricing In”
Since the 1960s, the “efficient market hypothesis” has been a prominent theory in finance. In essence, it states that market prices already incorporate all available information, including both past events and expectations about future events. Moreover, the “random walk theory” suggests that if markets accurately reflect all existing data, the only thing that can influence a stock’s price is entirely unexpected news.
In practice, this implies that most significant events are not entirely unexpected. Investors are generally adept at identifying market-moving events well in advance. As soon as rumors start circulating, the related asset’s price begins to adjust in anticipation of the event. And as the event becomes more or less likely, the price will respond accordingly. Therefore, by the time the event is officially announced, the price will have already shifted to account for the news.
Consider the example of Apple. If there are speculations that Apple is about to unveil a revolutionary product, investors begin buying Apple stock in anticipation, causing its price to rise. As more rumors circulate and excitement builds, Apple’s stock price climbs even higher. When Apple eventually makes the official announcement, the stock price barely moves because investors had already “priced in” the news.
How reliable is the efficient market hypothesis? Billionaire investor Warren Buffett reckons markets are quite efficient, but would advise a healthy pinch of salt with that hypothesis. He tends to ignore current news and instead focuses on a company’s fundamentals and long-term prospects. When it comes to short-term price movements, markets do tend to be pretty good at pricing stuff.
The impact of earnings updates on prices
How do stocks behave leading up to earnings updates? As mentioned earlier, financial markets usually anticipate market-moving news well in advance. This holds particularly true for company earnings updates, which reveal a firm’s recent financial performance.
Banks and investment firms employ teams of analysts to evaluate various metrics, market research data, and sometimes engage with customers and suppliers to assess a company’s financial health. These analyses lead to forecasts that are aggregated into a consensus view of what the market expects.
This consensus view, along with the company’s own earnings guidance, is integrated into the stock’s value before the earnings report is released. If earnings are expected to show growth, the stock’s price will likely rise. Conversely, if earnings are expected to disappoint, the stock may decline. Therefore, when the earnings report is finally released, the stock price might not move much because expectations are simply being met.
What happens when the earnings report deviates significantly from expectations? When a company surprises with earnings that either surpass or fall short of forecasts, the markets respond promptly and often with dramatic price swings. It’s worth noting that there is evidence suggesting companies being generally penalized more for missing expectations than rewarded for exceeding them.
Sometimes, a company may announce strong earnings that meet expectations, but its stock price still drops. This could be due to the company’s earnings guidance, indicating challenging times ahead, which doesn’t bode well for future growth. Predicting a company’s guidance can be tricky for analysts as they lack access to the same data as the company, making it challenging to forecast accurately.
How can you trade earnings? Analysts’ forecasts are not always infallible, and if you believe they’ve underestimated a stock’s potential, you might consider purchasing the stock before the earnings report and potentially benefit from a price increase. However, this approach involves risk, as you’ll be competing with experts who possess more data, technical expertise, and resources.
If you’re not confident in your ability to outperform analysts in the short term, you can adopt a longer-term perspective. Analysts often focus on the present and the immediate future, but by thinking further ahead, you might identify opportunities that may take longer to materialize but offer substantial returns in the years to come.
In summary, things are fairly simple when it comes to earnings news. But things get a little more complicated when considering the impact of news on the overall economy, which we’ll explore next.
How interest rate decisions influence markets
Central banks wield significant influence over the economy through their control of interest rates. Decisions to raise or lower interest rates can impact the cost of borrowing money, making growth easier or more challenging for businesses. Similar to earnings reports, central bank decisions are communicated regularly, but stock prices begin adjusting long before the official announcement.
Traders closely scrutinize every word uttered by central bank officials in an attempt to predict what’s coming. Over time, a consensus emerges among investors, indicating the likely direction of the interest rate change. This consensus, or market expectation, influences market movements.
However, central bank decisions are typically harder to forecast than company earnings because they involve committees of individuals with varying opinions. There’s no concrete data available to ascertain their exact thoughts before a decision is made. Although central banks aim to provide some guidance on the committee’s leanings, predicting their actions can still be challenging due to the lack of detailed, real-time information about their perspectives.
Trading central bank decisions often follows a popular strategy: “buy the rumor, sell the fact.” This entails buying stocks when rumors of an interest rate cut start circulating, capitalizing on the ensuing rally, and selling before the official announcement. This approach trades on market sentiment rather than the actual outcome, allowing traders to lock in profits if the rumors prove false or position themselves favorably if rates increase.
Nonetheless, trading central bank decisions isn’t without its complexities. It relies on market sentiment, and traders may miss out on additional gains if the expected rate cut materializes. Conversely, if rates are raised, they can buy stocks at lower prices after a market decline.
Can you outperform the market?
The mantra “buy the rumor, sell the fact” hinges on the idea that even anticipated news isn’t a guaranteed outcome. But can unexpected news fare any better?
In reality, the effectiveness of reacting to unexpected news can be limited. There’s typically a delay between the occurrence of an event and your awareness of it. Even with real-time news coverage, it takes time for journalists to verify stories, prepare them for distribution, and for you to execute a trade. An optimistic estimate might place this timeline at around 10 minutes.
In the world of modern finance, 10 minutes is an eternity. When you trade, you’re not just competing with individuals; you’re up against enormous financial institutions.
Professional traders possess tools and speed that can outpace the average investor. They receive news the moment it’s published through expensive wire services. Moreover, sophisticated AI algorithms analyze news and execute trades almost instantaneously.
Even in cases of unexpected news, it’s challenging to capitalize on the situation because stock prices adjust quickly, often before you hear about it, let alone act upon it.
Does this mean there’s no hope for individual traders? Not necessarily. Tyler Tebbs, the executive director of the event-driven group at broker Olivetree Financial, suggests that while markets react almost instantly, it’s crucial to consider if the reaction is accurate. News outlets may misinterpret stories or lack context, and algorithms, while smart, react based on the broader market’s sentiments. If you can identify something overlooked by others, you might outsmart the algorithms and seize opportunities.
Takeaway
When you trade based on news, you’re often trading on how investors respond to the news. Therefore, it’s up to you to decipher whether a particular bandwagon is worth joining or not. Delve deeper than the surface of headlines and critically assess what a company, central bank, or any relevant entity is truly communicating. With a discerning eye for the news, you can unearth opportunities that others may have missed.
