While polls show Hillary Clinton comfortably leading over Donald Trump for the U.S. Presidency, Clinton's victory is not guaranteed. Damaging revelations from the hacked DNC emails may still emerge. And perhaps silent Trump supporters are not forthcoming with pollsters, quietly hiding their voting intentions as pro-Brexit voters did.
Events with uncertain outcomes periodically pierce the calm of financial markets. Such events rivet attention and distort prices. We've seen dramatic price moves this year on the back of the Brexit vote. The U.S. Presidential election (and later European referenda) could hold similar surprises.
Such uncertainty about events can generate predictable patterns in financial market prices. Today's newsletter explores the nature of event-related uncertainty, how investors and prices respond to it, and how to best position ourselves around it.
Betting on the Unexpected
A significant body of academic research shows that investor sentiment in anticipation of events contributes to predictable price reversion following the outcome. The most frequent uncertain event in stock markets is corporate earnings releases. Studies of earnings releases find patterns in prices around these events. In particular, a recent academic study found that "stocks with extreme abnormal returns in the week before an earnings announcement experience strong price reversal around the announcement." (Jansen & Nikiforov, 2016). Prior researchers found this pre- and post-earnings price effect to be particularly strong and biased only to the upside before the event when associated with positive sentiment, as during the internet bubble (Trueman, Wong, & Zhang, 2003). It's not only around earnings events that such price patterns emerge. Academic researchers have also found that the Twitter sentiment prior to IPOs is predictive of a price reversal from the opening price of the IPO through subsequent days (Liew & Wang, 2016). The price pattern around anticipated events is stronger when media sentiment is correlated with the price action during the run-up to the event.
Markets are constantly in a state of uncertainty and flux and money is made by discounting the obvious and betting on the unexpected.
~ George Soros
This price pattern - excitement and price appreciation before an anticipated event leading to a subsequent decline after the event - gave rise to the market wisdom "Buy on the rumor, sell on the news". This pattern also occurs in reverse as "Sell on the rumor, buy on the news." After the initial price move in advance of the event, news of the event itself collapses uncertainty, and prices typically reverse.
At the heart of this pattern is 1) an event with an uncertain outcome, 2) sentiment building in favor of one result, 3) price following the sentiment, 4) an uncertainty collapse when the news is released, and 5) a price reversal following the event.
Tesla (TSLA) and Apple (AAPL) are two of the most psychology-driven stocks in the markets, and some of the best illustrations of this pattern occur around their product launches.
The following chart of Tesla shows how investors (and the TSLA price) responded from 2014 to 2016 before and after the announcement of the Gigafactory in 2014, the Model X in 2015, and the Model 3 in 2016. In all three cases initial enthusiasm became irrational, and from a peak of positive sentiment, prices fell back to earth. We published the below chart on LippperAlpha and Investopedia before the subsequent 20% fall in the TSLA share price over the following weeks. When short term average sentiment rises above long term average sentiment in the media about Tesla (both News and Social media), then the shading between the lines becomes green. When the divergence is large, short term irrational exuberance is possible.
Our Lipper article about this event contains additional tips on how to identify and trade such patterns around anticipated events.
Like Tesla, Apple experiences similar price patterns. Ass far back as 2002 the Wall Street Journal noted, "The Cupertino, Calif., company's stock increasingly has been caught in a strange cycle: In recent years, the shares have run up strongly in advance of product debuts -- and declined thereafter." (Tam, 2002).
One of our 2014 newsletters demonstrates the pattern - in an attenuated form - around the iPhone 5 and 6 launches. The following charts show a moving average of our MarketRisk index (a.k.a. the Bubbleometer) which measures speculative excitement versus analytical fundamental discussions in media. When the short term average is high, that means investors are becoming excessively speculative, and so the shading turns pink (as a warning). This shading convention is in line with the charts for the iPhone 5 and 6 in our prior newsletter and below.
The iPhone 5 release:
A similar pattern emerged around the commercial launch of the iPhone 7, as seen in the chart below. There was initial disappointment after the initial iPhone 7 press release ("What, no audio jack!?") followed by a burst enthusiasm into the launch and a price slide afterwards. The iPhone 7 release:
While the Apple price decline following the iPhone 7 release was only minor, such uncertainty-based patterns occur with regularity according to recent research.
The High Price of Consensus
As Warren Buffett noted above, investors occasionally overreact to uncertainty, creating opportunities for others who buy value stocks. Academics have found support for Buffett's assertion. High-uncertainty equities and country stock indices on average outperform their less ambiguous peers (Erbas and Abbas, 2011). The stocks of companies with ambiguous information on their balance sheets (e.g., research and development spending) that cannot traditionally be correlated with future valuations also outperform. Stocks with poorer earnings quality (having more uncertainty) also have greater long-term returns than those with better (more transparent) accounting (Kumar, 2009). As a result of aversion to ambiguous items on accounting statements, investors mistakenly avoid such stocks and miss out on greater long-term returns.
The future is never clear, and you pay a very high price in the stock market for a cheery consensus. Uncertainty is the friend of the
buyer of long-term values.
However, uncertainty isn't always positive for stock prices. The overall mood of investors influences whether uncertainty leads to outperformance. When investors are overall optimistic, uncertain stocks underperform over the subsequent one year. When investors are pessimistic, uncertain stocks outperform (Baker and Wurgler, 2006).
Government policy uncertainty is also influential on prices. Researchers into the effects of government policy uncertainty found that, “Stock prices fall at the announcements of policy changes, on average. The price fall is expected to be large if uncertainty about government policy is large.” (Veronesi & Pastor, 2011). According to those researchers, following the initial price decline, a bounce typically follows.
Systematic Study of Uncertainty
The patterns associated with uncertainty around specific events project themselves broadly into price patterns for baskets of stocks and currencies, where those associated with the most uncertainty tend to outperform those with the least. CJ Liu, MarketPsych's Head of Research, performed cross-sectional analysis of the Uncertainty TRMI across U.S. stocks. He found that annual and monthly media uncertainty correlated with stock price movement over the following month and year. The equity curve below was generated by identifying the top 100 U.S. stocks by buzz in the media over the past 12 months (both news and social media) and buying shares in the 20 with the most associated uncertainty and shorting the 20 with the least uncertainty. This rank and buy/sell pattern was repeated yearly and the equity curve represents the absolute return of this uncertainty arbitrage.
For discretionary stock investors, the general key to taking advantage of uncertainty is to identify where a broad “cheery consensus” exists and to strategically go against it. For global macro traders, George Soros suggests taking advantage of uncertainty where unexpected events are not being properly anticipated. For Soros, uncertainty is a constant in markets, and the key to profitability is to identify where unexpected events are being discounted. Both Buffett’s and Soros’s approaches are valid, and their differences illustrate the challenge of systematically defining and taking advantage of uncertainty in markets.
Housekeeping and Closing
The use of sentiment around such events isn't an exact science. In 2012, the S&P 500 was relatively flat in the weeks before the U.S. Presidential election. However, after the election the stock market dropped for 2 weeks and then rose into the end of the year. The flat price action before the election was a tip-off of no predictable market reversion following the election.
The fundamental law of investing is the uncertainty of the future.
~ Peter L. Bernstein
The U.S. election may drive coal, healthcare, and defense stocks to benefit if Trump pulls ahead in polls, while consumer stocks, technology, and the US Dollar will generally will benefit from a Clinton victory. If there is significant price movement before the election in those industries or assets, then following the election there may be reversals. (Although the outcome of this U.S. election is not looking uncertain at this stage and the patterns may not play themselves out).
The best way to invest through such events is not to anticipate the price action into the event, but rather to expect a reversion afterwards. If there is a sell-off before the election, then expect a rebound afterwards of approximately the same duration. If there is a rally into the election, then prices will likely fall afterwards. Keep in mind that there was actually a small week-long rally into the Brexit vote which then reverted mightily.
We love to chat with our readers about their experience with psychology in the markets. Please send us feedback on what you'd like to hear more about in this area. Read more about investing through uncertainty in stocks and currencies in our book "Trading on Sentiment: The Power of Minds Over Markets" (Wiley, 2016).
If you represent an institution, please contact us if you'd like to see into the mind of the market using our Thomson Reuters MarketPsych Indices to monitor real-time market psychology and macroeconomic trends for 30 currencies, 50 commodities, 130 countries, 50 equity sectors and indexes, and 9,000 global equities extracted in real-time from millions of social and news media articles daily.
Your monitors of global uncertainty,
Richard Peterson M.D. and the MarketPsych Team
• Baker M. and J. Wurgler, “Investor Sentiment and the Cross- Section of Stock Returns,” Journal of Finance 61(4) (2006), pp. 1645–1680.• Buffett, W. “You Pay a Very High Price in the Stock Market for a Cheery Consensus,” Forbes Magazine (August 6, 1979).
• Erbas S. N. and M. Abbas, “The Equity Premium Puzzle, Ambiguity Aversion, and Institutional Quality” (October 2007). IMF Working Papers, 1–58. Available at SSRN: http://ssrn.com/abstract=1019684.
• Jansen, I. P., & Nikiforov, A. L. (2016). Fear and Greed: A Returns-Based Trading Strategy around Earnings Announcements. The Journal of Portfolio Management, 42(4), 88-95.
• Kumar, A. “Hard-to-Value Stocks, Behavioral Biases, and Informed Trading,” Journal of Financial and Quantitative Analysis 44(6) (2009), pp. 1375–1401.
• Liew, J. K. S., & Wang, G. Z. (2016). Twitter Sentiment and IPO Performance: A Cross-Sectional Examination. The Journal of Portfolio Management, 42(4), 129-135.
• Peterson R. (2016). "Buy on the Rumor." Chapter 10 of Trading on Sentiment: The Power of Minds Over Markets, John Wiley & Sons.
• Tam, Pui-Wing. January 3, 2002. "Apple’s stock may tumble after new products debut." The Wall Street Journal.
• Trueman, B., Wong, M. F., & Zhang, X. J. (2003). Anomalous stock returns around internet firms’ earnings announcements. Journal of Accounting and Economics, 34(1), 249-271.
• Veronesi, Pietro, and Lubos Pastor, “Uncertainty about Government Policy and Stock Prices.” In 2011 Meeting Papers, no. 86. Society for Economic Dynamics, 2011.