Do Surprises Really Move Markets?
French economist Louis Bachelier long ago remarked: “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 will not change if the expected happens. It is the unexpected that causes prices to move.
In an efficient market, any new information the market receives will be random, not in the sense of being good or bad, but in the sense of whether it surpasses or falls short of the expectations that are already built into the current price.
The market quickly incorporates new information and revalues the security. The volatility of both the stock and bond markets is evidence of the frequency with which the expected fails to occur.
The following examples from my first book, “The Only Guide to a Winning Investment Strategy You’ll Ever Need,” demonstrate that 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.
Good News, Bad Results
On Feb. 4, 1997, after the market had closed, Cisco Systems [check out our ETF.com stock finder] reported that its second-quarter earnings had risen from $0.31 per share in the prior year period to $0.51, an increase of 65%.
No one would suggest that a rise in earnings of that magnitude is bad news. Yet the price of Cisco’s stock fell the following day from its prior close of just over $67 a share to $63, a drop of 6%.
The price drop can be explained by the fact that the market was anticipating a greater increase in earnings than the company reported. Prior to a company’s release of information, outsiders do not know whether it will report earnings higher or lower than market expectations.
Bad News, Good Results
A similar phenomenon occurs when a company’s stock price rises after a “bad” earnings report. For example, the day IBM [www.etf.com/stock/IBM] released its earnings for the second quarter of 1996, the price of its stock rose 13%.
Based on the price movement, one would have thought that IBM had announced spectacular results. Their earnings were, in fact, down about 20% from the same period of the prior year.
The stock rose because the market was expecting IBM to announce far worse results.
Because surprises are by definition unforecastable, whether subsequent information will affect the price of a stock in a positive or negative manner is random. The fact that the academic research, including papers such as “Luck versus Skill in the Cross-Section of Mutual Fund Returns,” has found that fewer active managers (about 2%) are able to outperform their appropriate risk-adjusted benchmarks than would be expected by chance demonstrates that the markets are highly efficient at setting prices.
Despite the research findings, there remains a huge industry dedicated to trying to outguess the “collective wisdom” of the market and exploit surprises. The investment research team at Vanguard provided some insights into just how successful you might need to be to exploit economic surprises in its November 2018 paper, “Here Today, Gone Tomorrow: The Impact of Economic Surprises on Asset Returns.”
They began by noting that the belief that motivates tactical allocation strategies is that a surprise can be foreseen by prescient analysts. With that in mind, they asked the question: “How prescient do you need to be to exploit economic surprises?”
To answer that question, they built a simple model using data from the last 25 years. The economic measure used is the nonfarm payroll.
They start with a 60% U.S. equity (represented by the MSCI USA Index)/40% U.S. bond (represented by the Bloomberg Barclays US Aggregate Bond Index) portfolio.
In advance of any positive economic surprise, they increase their equity allocation to 80%.
In advance of any negative economic surprise, they decrease their equity allocation to 40%.
Not surprisingly, they found that if you had perfect foresight, your returns increased. However, the improvement in returns was just 0.2% per annum—and that’s before even considering trading costs, and for taxable investors, taxes. To break even with the 7.4% return of the benchmark 60/40 portfolio, the investor would have had to be right 75% of the time (again, that is before considering implementation costs).
Given today’s highly competitive markets, the odds against being able to successfully exploit mispricings after implementation costs seem daunting. Yet in a triumph of hype and hope over wisdom and experience, most investors are still engaged in that endeavor.
Vanguard’s research team concluded: “The odds of successfully trading on surprises is low.” They added: “What can seem consequential in the short run is irrelevant to the long-term investor. Short-term surprises are quickly priced into long-term expectations, and these long-term projections have almost no relationship to future returns.” (There is little relationship between economic growth and stock returns.)
I hope you will keep Vanguard’s findings in mind the next time you are tempted to tactically allocate based on your (or some guru’s or money manager’s) forecasting ability. And if you are still tempted, remember that an all-too-human trait is overconfidence in our abilities.
I offer one other suggestion: Start keeping a diary, writing down every time you are convinced the market is going to go up or down. After a few years, you will realize that your insights, unfortunately, are actually worth nothing.
Larry Swedroe, Director of Research BAM Alliance
This commentary originally appeared January 28 on ETF.com
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