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.
Surprises Unforecastable
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.”
