Saturday, May 23, 2009

Reaction and Over-reaction

One seeming constant I have observed over my more than a decade of trading for my living is how the markets tend to react and often over-react to various events and news. Have you noticed, for example, how often a stock price will dip following an earnings announcement even when the announcement is good? Sometimes, we see the price of a stock literally plummet when it misses predicted earnings by a penny or two. What causes these sharp moves?

At least in the shorter term, it is no secret that market movement is a gret deal more psychological than logical. Have you ever attended a home owners' association meeting where the subject may affect property values and seen the raw emotion evidenced by the crowd? How about the audience reaction at a governmental meeting where a zoning change is discussed, or a half-way house is trying to open in a community. Manners and civility are forgotten and a mob mentality prevails. All I need do in one of these articles is take any position regarding something like taxation or social security and the battle is waged. The blog is filled not only with varying opinions but also with vitriolic verbiage. Emotions simply take over and often seem to overshadow reason.

I suggest the same kind of psychology often prevails in response to stock market related events and news. A stock "misses earnings" by a couple of cents and share prices fall $5 or $10. Does that make logical sense? In some cases it may, but in most, it is an over-reaction fueled by fear that the company isn't doing well.

If we take a moment to stop and think about it, what does missing earnings really mean? In general, it simply means that an analyst or a bunch of analysts were wrong in their guess. Truth is, they are often wrong. The same is true about the predictions of economists. They predict so many things including retail sales, unemployment numbers, GNP, inflation, and on and on and, it seems to me are correct about as often as the weather man. Rationally, we know it is impossible to predict these things with complete accuracy, but the irrational, emotional side of us often over-reacts when these predictions (that we know from experience are often mistaken) turn out to be wrong.

Who can predict tomorrow? If I as a trader say I think the market will go up tomorrow and it doesn't, would that be a surprise? Of course, it wouldn't. World events, a war breaking out, a terrorist attack, a company failing unexpectedly, a corporate officer being charged with a crime all could influence the market movement.

As traders, I believe it is important for us to be aware that the markets react and over-react emotionally when a prediction of the unpredictable fails to hit the mark. Though we may rationally conclude that the failure of a prediction should not be unexpected, we can be aware that it nevertheless can result in a market consequence. That awareness can help us gain an edge in our own trades. In short, the knowledgeable can position themselves to take advantage of the over-reactions of the emotional.

Thanks to those of you who have been buying the new book, "Smart Investors Money Machine," and to those of you who have ordered my DVD. I sincerely hope both add to your investment successes.

by Bill Kraft, Editor
Copyright 2009, Makin' Hay, Inc.
All Rights Reserved

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Walt said...

I agree with your post. Emotions frequently overrule reason. Yet when an earnings miss is followed by a hugh price drop there is often more to the story than the headlines. The real news comes later in the conference call when the company makes projections for the future. That is often the driving force for the hugh price movement.

Bill Kraft, said...

Good point, Walt. Thanks for writing. I did want to emphasize that there often is a price drop (though not necessarily huge) even when earnings are decent.
Bill Kraft

Anonymous said...

of course the mkt. is emotional. It's the psychological summation of the people. My opinion: earnings are well overstated or underated most of the time. Nothing like 6 people looking at the same numbers from different perspectives/influences. Standardized in theory or intent perhaps. Also consider where the market is now and that groupthink is still alive and well. Does anybody " get" what's happening. Most don't I'm afraid...or is that i'm afeared. You're a good man Bill Kraft.

Bill Kraft, said...

Thanks, Anonymous. Your post hits some important points.
Bill Kraft