Always have a trading back-up plan…
Even in a market that makes little-to-no sense, there’s always a way to make money. This is why we often remind readers of our popular trading strategies to do just that.
Trading information friction… and why there’s time to buy Transocean
Eugene Fama’s 1973 Efficient Market Hypothesis says that when news is released, it is immediately reflected in the price of stocks. And for years, that was popular thought.
In other words: He felt that markets efficiently and instantaneously process new information.
But he was wrong…
Take a look at Transocean (RIG), for example.
Here’s a stock that’s just starting to perk up off multi-year lows on news that Wall Street overreacted by sending RIG down so much… that RIG wasn’t in the same trouble as BP.
Plus, we’ve got news that BP agreed to indemnify RIG for any accidents — including spills. And unless BP can prove a deliberate act on behalf of RIG or negligence, the full cost of the disaster falls on BP.
And that news is just beginning to circulate.
It’ll move from the source to multiple audiences through multiple channels of communication — the direct cause of information friction.
What’ll allow us to trade that friction — or the delay in the dissemination of news to a greater number of investors — is the speed that news is disseminated.
Sometimes, the news or rumor we pick up on won’t be fully disseminated, meaning the intended audience won’t get it until later in the day when they get home from work. And by then, we’ve already bought the stock and are just waiting for the trigger (the nightly news report, for example) that’ll throw gasoline on our small flame.
You see, by constantly monitoring the early-phase information sources (most of which are online), we learn the important news first and can make buy recommendations. That’s the first tier of trading on news.
As more investors learn of the news through dissemination, price and volume begin to soar depending how good or bad the news is. This is the second tier of trading on news.
The third tier of trading news is the reaction to the reaction. By nightfall, you might hear of the story on CNBC or see it the next morning in the Wall Street Journal. And way down the line, the story may make the weekly magazines like Time, Newsweek, Business Week, or Forbes — piquing further interest and leading to buying activity in the stock.
It’s why Eugene Fama was — and is still — wrong
Not all news is baked into the market.
I’ve taken my bumps and bruises discounting the efficient-market theory, but I disproved its validity… as did Evans and Lyon’s report in the Journal of International Money and Finance (2004):
The market could still be absorbing or reacting to news releases hours, if not days, after they are released. The study found that the effect on returns generally occurs in the first or second day, but the impact does seem to linger until the fourth day.
Efficient market theory has also been disproved by the following studies:
“I examine returns to a subset of stocks after public news about them is released. I compare them to other stocks with similar monthly returns, but no identifiable public news. There is a major difference between return patterns for the two sets. I find evidence of post-news drift, which supports the idea that investors under-react to information [ . . . ] There is a large amount of evidence that stock prices are predictable.”
— Wesley S. Chan, M.I.T. – Stock Price Reaction to News and No-News: Drift and Reversal after Headlines
“Arguably, the most important process affecting price movements is the news arrival process. For example, in Ross (1989) the volatility of stock price changes is directly related to the rate of flow of information to the market [ . . . ] On days no news arrives, trading is slow and price movements are small. When new information arrives that results in a change in expectations, trading becomes vigorous and the price moves in response to the impact of the news [ . . . ] In addition to price movements, news arrivals can affect the time between trades, number of transactions, and volume of trade.”
— John H. Maheu, University of Alberta, and Thomas H. McCurdy, University of Toronto, News Arrival – Jump Dynamics and Volatility Components for Individual Stock Returns
“Periods of good news are followed by periods of unusually high returns relative to natural benchmarks, with the reverse for bad news [ . . . ] Post-event drift is the tendency of individual stocks’ performances following major corporate news events to persist for long periods in the same direction as the return over a short window—usually one to three days—encompassing the news announcement itself.”
— Andrew Jackson and Timothy Johnson – Unifying Under-reaction Anomalies
But the question remains: Can the average investor really profit from news without having proprietary research?
As a study from the Harvard Institute of Economic Research observes, “New technology is rapidly democratizing securities markets. The costs of gathering information and executing trades are being driven to negligible levels. These changes allow a rapidly growing base of investors to participate in the financial system.”
And your sources are at your fingertips
Most of the time, there’s no big secret to the kind of news that makes a stock jump:
- Insider buying
- Buybacks (repurchase agreements)
- Stock splits or dividends
- Rumor or news
- A big new product or major contract award
- FDA approval for a new drug
- Successful clinical trial for a drug candidate
- The FCC granting a license
- Big order from government
- High-profile joint venture announcements
- Commercialization of new technology
- Spikes in volume, message board chatter
- Senseless stock or sector sell-offs
- Bidding wars
- Press releases circulated to shareholders or those on mailing lists
- Press releases sent to major news providers such as Yahoo!, SmartMoney, CNN, MSNBC, CNBC
- Massive increases in volume and mentions in lists of best daily performers
… And so on. The real beauty of trading on the news is the gradual spread of news from the few to the many; it simply proves that a lag in time can be exploited for profits.
But average investors don’t move fast enough.
Sure, they’ll learn about it on the evening news or the next day in the newspapers… but by that time, they’ve left money on the table. Fortunately, it’s quite easy for us to get in on the ground floor time and time again.
Continuing with our Transocean (RIG) buy idea, here’s another reason the stock could pop.
The majority of RIG’s projects are still operating normally. RIG is well diversified. RIG has good cash flow… and even if the results of proceedings and investigation go “worst case,” any legal obligations would probably be delayed for many years.
The only problem for RIG is the offshore drilling moratorium… but that could be priced in.
Bottom line here: Wall Street overreacted and it will continue to do so.
But we are looking for higher prices as diminished liability news makes the rounds. Don’t risk the house on this trade, though… Invest lightly and then add, as the stock moves up.
Oh, and stay away from (or short) BP. The company is estimating that a worst-case scenario rate for the Gulf of Mexico oil spill could be about 100,000 barrels of oil a day.
Stay Ahead of the Curve,
Ian L. Cooper