"Disaster Trades" Are Always a Terrible Idea
It’s difficult to stay away from the television while the biggest hurricane to hit the U.S. in more than a decade dumps more than two feet of rain on a major city.
Hurricane Harvey continues its onslaught of the Houston area this morning. Meanwhile, the financial noise machine is in overdrive trying to deduce how the storm will affect everything from oil production to stocks.
Even during a crisis, Wall Street only has one thing on its mind…
What does it mean for the markets?
But here’s the truth the financial noise machine doesn’t want you to know: There’s no strategy to successfully gauge how a news event or story will play out in the markets – even unexpected natural disasters.
You can’t trade news events. Well, you can. But only if you enjoy losing money.
Just look back to every Fed meeting, jobs report, or big earnings announcement. The media plays up every angle, from how the event could end in disaster and probably ruin the economy and the markets and everything in between.
After all, humans are constantly seeking organization in a highly unorganized world. When the markets fail to follow the script, we just don’t know how to react. That’s the big problem with trading on events and news stories. The market’s already three steps ahead of you. You can’t outsmart it…
If you’re going to rely on price action to guide your trading, you need to understand the three main reasons you can’t think like a “news trader”:
1. Correlation does not equal causation
Every single day, the financial media posts its market wrap-ups. These reports summarize the day’s activity, give you the closing prices for the major exchanges, and maybe prices of a few foreign markets if there was any action overseas.
But the financial reporters don’t just offer up a bland list of numbers and prices. There’s always a specificreason assigned for the gains or losses of the day. Stocks moved lower because of poor manufacturing data. The market dropped because of strong earnings from a couple of blue chips. Or maybe stocks retreated because a few folks decided they didn’t like one of Trump’s tweets.
But is any of this true?
Did millions of buyers and sellers collectively decide to buy or sell for any of these specific reasons? Do you think these reporters sent around an email survey to every investor on the planet and tallied the results?
It’s impossible to know for sure why the markets do what they do every day, yet it is reported as fact by the financial media. Not only is this insane – it’s also completely misleading.
As a rule, a market event can be discounted once and only once.
What does this mean?
Let’s say the markets are rocked by an unexpected announcement. The major averages fall more than 1%. And for the next week or so, additional news stories about this event continue to dissect and project what it could mean for the economy. Conventional thinking says that the market should continue to fall as the “bad news” is amplified. But that’s not necessarily true.
News happens. It is discounted once. If you own 100 shares of a stock and you wish to sell, you can sell your 100 shares only one time. The same is true on a larger scale. Unless there is new information, investors will discount a news item only once. Once the initial round of selling is over, you’re left with those who have decided to hold despite the information and those who sold due to the information. Until some new development changes minds, the event is in the rearview.
Remember, the market is forward-looking. Anticipation is more important than a reaction to an event that has already happened…
Expectations have a big impact on how news is received. Just imagine a company reporting earnings. Management could send out an optimistic release detailing how revenue grew 10% the previous quarter, with earnings clocking in at record highs.
But if investors were expecting 15% growth and even better earnings numbers, the stock would probably sell off. No matter how upbeat the news might be, the reaction to the event depends largely on the expectations of buyers and sellers.
The same is true of big events. If investors were expecting a big budget deal the night before a deadline — and the government delivered — the reaction would probably be muted at best. What was “supposed to happen” came true. If there’s no big surprise, it’s unlikely that any opinions on the matter changed at all.
The unexpected moves markets. Expected outcomes are usually already priced in.