How To Better Trade The News To Profit In The Market
By
Avi Gilburt
How To Better Trade The News To Profit In The Market
I can provide one word of advice to you regarding the title of this article, which is the same advice that President Biden provided to Iran over a year ago: DON’T!!
The way investors and pundits sit on the edge of their seats with baited breath in anticipation of market moving news when these reports are published makes most novice market participants believe these reports are the primary drivers of the stock market. Yet, for the last seven weeks, the market has not had any economic news announced due to the government being shut down. So, did the market not move during that time? Or, did the market decline when the government shut down, as many believed it would?
The funny thing is that the market rallied when the government shut-down began, and then declined when it re-opened.
So, does that mean you now engage in mental gymnastics to explain this anomaly relative to common expectations? Or, are you going to be more honest with yourself and recognize that the shut-down, and even the economic reports, are ultimately meaningless to the market?
Yes, I know you have seen past instances where the market has rallied on positive economic news and declined on bad news, which solidified your perspective that these reports matter and drive the market. But, if you really maintain this perspective, it also means you ignore all those many times when the market rallies on a bad economic report or falls after a good economic report, or you simply have performed mental gymnastics to try to explain it.
As I post quite often, I think this quote from Robert Prechter’s seminal book about market dynamics, The Socionomic Theory of Finance, (which I could not more strongly suggest reading) provides incredible insight into the common investor’s perspective regarding how they treat news and reports:
“Observers’ job, as they see it, is simply to identify which external events caused whatever price changes occur. When news seems to coincide sensibly with market movement, they presume a causal relationship. When news doesn’t fit, they attempt to devise a cause-and-effect structure to make it fit. When they cannot even devise a plausible way to twist the news into justifying market action, they chalk up the market moves to “psychology,” which means that, despite a plethora of news and numerous inventive ways to interpret it, their imaginations aren’t prodigious enough to concoct a credible causal story.
Most of the time it is easy for observers to believe in news causality. Financial markets fluctuate constantly, and news comes out constantly, and sometimes the two elements coincide well enough to reinforce commentators’ mental bias towards mechanical cause and effect. When news and the market fail to coincide, they shrug and disregard the inconsistency. Those operating under the mechanics paradigm in finance never seem to see or care that these glaring anomalies exist.”
Allow me to show you some studies which provide evidence that these reports and the shut-downs really do not matter to the market (assuming you do not want to believe your lying eyes for these last seven weeks).
In 1997, the Europhysics Letters published a study conducted by Caldarelli, Marsili and Zhang, in which subjects simulated trading currencies. However, there were no exogenous factors that were involved in potentially affecting the trading pattern. Their specific goal was to observe financial market psychology “in the absence of external factors.”
One of the noted findings was that the trading behavior of the participants were “very similar to that observed in the real economy.“ Isn’t this what we experienced over the last seven weeks without any economic news or government intervention?
Well, if you are still skeptical, what do you think about a study analyzing the actual effect of economic news? In a 1988 study conducted by Cutler, Poterba, and Summers entitled “What Moves Stock Prices,” they reviewed stock market price action after major economic or other type of news (including major political events) in order to develop a model through which one would be able to predict market moves RETROSPECTIVELY. Yes, you heard me right. They were not even at the stage yet of developing a prospective prediction model.
However, the study concluded that “[m]acroeconomic news . . . explains only about one fifth of the movements in stock market prices.” In fact, they even noted that “many of the largest market movements in recent years have occurred on days when there were no major news events.” They also concluded that “[t]here is surprisingly small effect [from] big news [of] political developments . . . and international events.” They also suggest that:
“The relatively small market responses to such news, along with evidence that large market moves often occur on days without any identifiable major news releases casts doubt on the view that stock price movements are fully explicable by news. . . “
Again, does this not make even more sense now after not having economic news over the last seven weeks?
Well, of course, we are going to have those doubting Thomas’s who will try to explain all the movement with earnings reports. Guess what? I have a study for you on that too!
In 2008, another study was conducted in which they reviewed more than 90,000 news items relevant to hundreds of stocks over a two-year period. They concluded that large movements in the stocks were NOT linked to any news items:
“Most such jumps weren’t directly associated with any news at all, and most news items didn’t cause any jumps.”
And, if you want to understand a bit more about how earnings affect the market, feel free to read this article I wrote a number of years ago:
So, of course, the next logical question is going to be how do we explain these phenomena? Well, how about another study which outlines a very different perspective of market dynamics based upon mass psychology? Yes, I’ve got one of those too!
In a paper entitled “Large Financial Crashes,” published in 1997 in Physica A., a publication of the European Physical Society, the authors, within their conclusions, present a nice summation for the overall herding phenomena within financial markets:
“Stock markets are fascinating structures with analogies to what is arguably the most complex dynamical system found in natural sciences, i.e., the human mind. Instead of the usual interpretation of the Efficient Market Hypothesis in which traders extract and incorporate consciously (by their action) all information contained in market prices, we propose that the market as a whole can exhibit an “emergent” behavior not shared by any of its constituents. In other words, we have in mind the process of the emergence of intelligent behavior at a macroscopic scale that individuals at the microscopic scales have no idea of. This process has been discussed in biology for instance in the animal populations such as ant colonies or in connection with the emergence of consciousness.”
The more we study market psychology, the more we learn that it is indeed the primary driver of major market movements as opposed to some exogenous factors such as news, economics or earnings. Of course, many of you will still doubt all this proof because you have personally seen how good news can move markets up and bad news can move markets down. So, allow me to explain it within this psychological perspective.
During a positive market trend, news is usually good during the heart of the move. That is why a good report can seemingly “cause” the market to move positively. But, it still leaves the question as to why the market will still go up even though bad news hits the tape? You see, the ultimate issue is the nature of the underlying market psychological mood. When the mood is positive, then even though bad news hits the tape the market will still move positively. That is why we often see the market shrug off bad news reports and continue moving higher during a positive sentiment trend. And, the reverse is also true.
To explain it a bit differently, external events affect the markets only insofar as they are interpreted by the market participants. Yet, such interpretation has been guided by the prevalent social mood or market sentiment. Therefore, the important factor to understand is not the social event or report or earnings itself, but, rather, the underlying social mood which will provide the “spin” to an understanding of that external event. Doesn’t this provide you with a much better and consistent explanation as to how markets really work?
You have just lived through a seven-week period without economic reports and the markets did not care. In fact, the markets moved higher when the government shut down and then fell hard when it re-opened. Are you going to shrug this off or perform mental gymnastics to try to explain it and simply move on? Or, are you going to dig a bit deeper beyond the superficial views of a novice investor and seek a better way to understand and track the market? The decision is yours. And, I can assure you that the correct decision can change your life. I have heard how it has changed 8000+ of our client’s lives over the last 14 years.
