Do Surprises Move Markets?
Here’s a quote from a long time ago by brilliant French economist, Louis Bachelier:
“Clearly the price considered most likely by the market is the true current price: if the market judged otherwise, it would not quote this price, but another price higher or lower.”
Prices don’t change when the expected happens
It’s the unexpected that causes prices to move.
What this means is that, in an efficient market, any new information the market receives will be neutral, not necessarily good or bad. But more importantly, whether it surpasses or falls short of the expectations that are already built into the current price.
Does this make sense?
Any new information is quickly absorbed by the market and the securities (i.e. stocks) will get revalued pretty much instantly.
How do we know this?
You might be asking yourself, “Tim, how do you know this to be true?” Well, I’m not making any of this stuff up. You can see for yourself. I’d say the biggest evidence to this being true is just how frequent the volatility of both the stock and bond markets is. Wouldn’t you agree? It’s pretty volatile.
That tells us that what the markets expected didn’t occur. If what was already expected DID occur, then there wouldn’t be any movement. It would be very stable and linear. Not volatile.
Again, at the end of the day, it’s surprises (not whether news is good or bad) that drive changes in prices. They show how good (bad) news can lead to bad (good) results.
Keep in mind, people are making bets on both sides, so good or bad news is always relative to who’s making the bet.
When good news equals bad results
Here’s an example of what I’m talking about:
On Feb. 4, 1997 Cisco reported that its second-quarter earnings had gone up from $0.31 a share to $0.51. Woah, this is awesome news! This is an increase of 65%!
I don’t think anyone would say that that kind of increase would be bad news. But the very next day, Cisco’s stock price dropped by 6%!
So what the heck happened?
Well, the problem was that the market was HOPING for a greater increase in earnings than the company reported. Before a company’s release of information, outsiders do not know whether it will report earnings higher or lower than market expectations.
So it all boils down to peoples’ expectations.
Does this make sense?
When bad news equals good results
A similar thing happens when a company’s stock price rises after a “bad” earnings report.
So here’s an example on the flip side:
For example, in the second quarter of 1996, when IBM released its earnings results, their stock went up 13%. But what was weird was that their earnings were down 20% from the same period, the prior year.
You’d think that the opposite would happen right? Earnings are down, so wouldn’t the stock price go down?
Their stock price went up because the market was expecting IBM to announce far worse results.
Surprises are impossible to forecast
Why are surprises called surprises?
Haha, because they’re surprises! By definition, it’s random and unforecastable. So you don’t know if something coming down the pike will result in your stock prices going up or down. Only God would have information to that. And I ain’t God.
Academic research, including papers such as “Luck versus Skill in the Cross-Section of Mutual Fund Returns,” found that only about 2% of active managers (these are professionals, not random day traders) are able to outperform their appropriate risk-adjusted benchmarks (I know this is a bit confusing, but long story short, no one knows what the heck they’re doing).
But despite the research, we still have active traders
I don’t know what it is, but even I still do this.
And I think it stems from ego.
Thinking that you’re smarter than you really are. And it’s not just me. There’s a huge industry dedicated to trying to outguess the “collective wisdom” of the market and exploit these sorts of surprises.
Take a look at this if you need further convincing. The investment research team at Vanguard wrote this in one of it’s papers just a few months back:
Anticipating the surprises to make the big bucks
Take the time to read the paper I linked above. The research team at Vanguard found that if you had absolute perfect foresight, your returns increased. BUT! And this is a big but. The improvement in returns was just 0.2% a year; and that’s before even considering trading costs and taxes!
In order to break even with the 7-8% return of an average benchmark portfolio, you’d have to be right 75% of the time (all day, every day), even before factoring in trading costs and all that jazz.
It’s not that you’re not smart, it’s just that there are a ton of smart people
Look, I’m not saying your ability to invest is bad. You might be really smart. Smarter than me (which wouldn’t be difficult, I assure you).
But the problem is that there are millions of other equally smart, or smarter, people betting against you or already thought of what you thought of. Not only are their individuals that are like this, but there are teams of people like this. There are companies and big institutions that are making bets on the same stuff you’re betting on.
So be realistic. Don’t be too overconfident in your own abilities.
If you’re still tempted to actively day trade, here’s something I highly suggest you try: have a journal where you write down every time you’re convinced of something; and check back in like a year later and see if you were right or wrong. I bet you at least 70% of the time, you’re wrong. And if you can’t be right the majority of the time, you’ll lose money in the long run.
We all forget our mistakes super easily, but overinflate our victories. Again, it’s an ego thing.
Markets are super efficient. And no single person knows what the heck they’re doing. Everything else is just the ego talking.
The markets already incorporate all known information and everyone’s expectations for the future. So what moves a stock price is not whether it’s good news or bad news, but whether the news is better or worse than what was expected.
This is an extraordinarily difficult game to play. And even the pros performing active management don’t play it very well; so be realistic!