Buy the Rumor, Sell the News

by Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research
October 7, 2008

The $700 billion Emergency Economic Stabilization Act of 2008 was signed into law on a October 3, but the market action took many investors by surprise as the bill that was supposed to stabilize the financial markets was greeted with a sell-off. This market weakness followed a giant sell-off on September 29, when the bill didn't pass. So what did the market want? It sold off in both scenarios.

It's important to remember that the market, in the short term, oftentimes trades on expectations. When those expectations are met, the trade is over, and often the market will move in a direction that may not make sense given the event actually coming to fruition. You may remember in early September when rumors started circulating that the federal government would intercede in some enormous way that the market quickly and substantially rallied. The government intervention was then largely "priced in" to the market.

In a relatively surprising development, however, the House failed to pass the bill on September 29, the market's expectations were dashed, and the market sold off. The market then meandered around the unchanged mark, and expectations again built that the bill would be passed. When that occurred October 3, the market participants then began looking toward the next thing in the future on which to trade, and didn't love what they saw—the global economy might take a bigger hit than previously expected.

We see this expectation versus reality trade all the time in the market. You can watch an individual stock at earnings time. If the company meets expectations and provides guidance in-line with what the market was already expecting, that has already been priced into the stock, and the stock will often trade flat to lower, no matter how great the results, as long as they just meet expectations.

On the opposite side of the game, when a company exceeds expectations on an earnings release, even if the original expectations were for pretty rotten results, the stock can often trade higher. Again, these are often short-term phenomenas and fundamentals will again take over. This is one of the reasons that it may pay to take a look at Schwab Equity Ratings when looking at a stock to try to gauge its longer-term prospects. The company that posts poor results consistently, even if it beats expectations, will likely lead to poor long-term stock performance.

On a longer-term basis, when looking at the overall market's earnings expectations, the notion of trading on expectations is important, as well. Ned Davis Research shows that when earnings expectations are low (5% growth rate or below), the market has tended to perform better in the following year (+15.5% vs. average return of 8.9%). This is because the market has priced in the dour expectations of earnings, but then begins to look across the valley, so to speak, to a recovery in earnings.

In terms of general economic growth, the market doesn't wait for the economic data to reflect a recovery. Historically, it has tended to bottom about five months prior to an economic upswing reflected in the data.

Finally, back to a current market example—we saw a bit of the expectation game on Monday, October 6, as the Dow was down close to 800 points but managed to close "only" 369 points lower. We believe part of the reason for the fierce 450-point rally in the matter of an hour can likely be attributed to growing speculation that the Federal Reserve would be making some sort of major move in order to help support the market. Again, this was an example of moving higher on expectations. If we fail to get Fed action, or the move isn't sufficient enough relative to expectations, we believe you can look for another move lower on the market in the near term.

Of course, the market is not so simple. There are many events playing out simultaneously. Deciphering what news and what expectations are built into the market at any given time is not an easy task. In addition, unexpected events can always throw the market a curveball. But "buy the rumor, sell the news" is a phrase that has some historical backing on the Street, and can help investors reconcile otherwise confusing moves in the market.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to see.

Schwab Equity Ratings are assigned to approximately 3,000 of the largest (by market capitalization) U.S.-headquartered stocks using a scale of A, B, C, D and F. Schwab's outlook is that A-rated stocks, on average, will strongly outperform, and F-rated stocks, on average, will strongly underperform the equities market over the next 12 months. Schwab Equity Ratings are not personal recommendations for any particular investor. Before buying, investors should consider whether the investment is suitable for themselves and their portfolio.

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