A new investor has a thousand ways to be confused by the stock market. Hearing the old adage ‘buy the rumour, sell the news’ won’t help.
What on earth?!
Why buy shares when you’re not sure what’s going on?
Or sell when a great thing is finally confirmed?
Why be uncertain at all in 2021 – when the facts are just a Google away?
If you’re asking these questions, then you don’t yet understand how markets work.
Which is what makes this old instruction so – well – instructive.
Buy the rumour because the market prices forward
Buying the rumour is all about what is priced into a share – and when – and whether you have an edge against your fellow share sharks.
In theory, a share price reflects the market’s best guess as to the current value of all the cash that will ever come due to its holder in the future – with a discount applied for risk and the time value of money.
Of course, prices can be buffeted by emotions and fads. This is what we mean when we gravely intone how a share “has become disconnected from fundamentals”. Recall, say, the manic trading of GameStop in early 2021.
But most of the time, most of the share price in an efficient market reflects a best estimate of a company’s cash generation potential.
Granted, this theoretical truth is seen best in an economist’s model. It’s not always so apparent in the hurly burly of a real-life stock exchange.
Not least because the market is no single entity. There’s no godlike bookkeeper with one eye on Excel and the other eye on the newswires.
Rather the market comprises millions of individuals, funds, and AI algorithms churning billions of shares. There’s a wide disparity in aims and time horizons. There’s also a varied appetite for risk and reward.
Mr Market has many faces
Sometimes in aggregate investors are greedy, and will pay a lot for future cashflows. That leads to higher equity prices.
Other times they’re scared and are prefer the certainty of cash in the bank. This reduces the general appetite for shares.1
Much of the time, very few market participants are seemingly doing any sort of discounted cash flow analysis or similar on those future earnings at all.
Instead they are chasing news. Or rising prices. They are buying because of an economic report or a release from a rival firm. Or a million more reasons.
A fund manager may pay more because it was sunny on the way to work, or because her database says a share is priced cheaply compared to history.
An investor may put money into Tesco because he just did his shopping there. He may buy on the rumour that a new gizmo is already selling out. He may sell on a hunch that a popular CEO is leaving.
Yet the object of most of this guesswork typically does have some bearing on future earnings. Okay, not that sunny commute maybe, but leadership changes or a smash hit product will impact the bottom line someday.
It all adds up.
You can think of a share price’s moves in the short-term as almost like the result of ‘Asking the Audience’ in Who Wants To Be A Millionaire.
Trades on a stock exchange are like votes cast with money.
Told you so
Sooner or later, any bit of guesswork is confirmed or refuted.
A CEO stays or goes. The hit Christmas toy sells out – or it transpires such rumours were a marketing stunt. Or maybe the toy does sell out, but only because they didn’t make enough of them. As a result the anticipated earnings boom never happens.
When millions of rumours are replaced by more knowledge in this way – whether through formal press releases, or by altering the profit and loss statement or the balance sheet in a firm’s reporting – mis-pricing begins to be corrected.
A bit of froth is taken off a share price here. Some gloom is dispelled there.
And so – over the long-term – share prices track earnings.
True, you may have to wait an age to see this. Think Amazon or Tesla.
Alternatively, the relationship between profits and a share price might be apparent quite quickly with a consumer staples company like Unilever.
Cyclical outfits such as miners typically see their share prices rise and fall well ahead of big earnings changes, like cats chasing their own shadows.
And did you notice I said ahead of earnings?
Wait for a cyclical company to confirm a downturn and you’ll probably have already taken a chunky loss by the time the news arrives.
Guessing ahead is the name of the game with cyclicals.
Buy the rumour to buy mispriced shares
Hopefully the adage ‘buy on the rumour sell on the news’ now makes sense.
If you’re trying to beat the market, you need to think and do something different to the market in aggregate, as represented by current share prices.
You might value a particular security differently.
Perhaps you’re operating at a different timescale to most participants?
Maybe you have a different attitude towards risk and reward.
(An apparent bargain price is often just a discount applied by the market to reflect the chances of something good and expected never happening.)
In any event, in most cases being able to anticipate something before it happens will be more profitable than waiting until everybody knows about it from an official news release.
Sure we can argue at the margins.
For example, the momentum factor’s history of out-performance may be due to investors taking longer than expected to properly incorporate new information – even when fully confirmed – into their valuations.
Meanwhile a lover of so-called quality shares like Warren Buffett or the UK’s Nick Train might argue the market systemically undervalues long-term compounded earnings generated by duller, more predictable companies.
I’m the sort of investing nerd who would happily debate all this with you in the pub, but that’s for another day.
Just make sure you grasp the main point before you look for exceptions.
Don’t be that guy
Don’t be like the talking heads on financial TV who every day seem amazed: “Monevator Enterprises shares soared after-hours despite reporting big losses”.
The market already knew that losses were coming. Investors expected even bigger losses. Or they didn’t appreciate a shift in the earnings mix. Maybe they like the new-news that the CEO is flogging off the loss-making divisions.
Or perhaps it’s one of a hundred other things.
“Why have my shares plummeted after Monevator Inc. reported record profits? The stock market is insane!” – say day traders everywhere, every day.
Perhaps the market is indeed slightly over- or under-pricing your shares. (It’s very unlikely to have the valuation right on the nose.)
Or maybe it has cottoned on to the fact that the surge in revenues at your company looks unsustainable.
That your company is juicing profits by under-investing.
Or a hundred other things.
If I had a drink for every time I’ve heard media pundits or online posters bewailing an ‘irrational’ market that in fact was looking months or years ahead – and long before you were – then I’d be checking myself into the Priory.
Not least because I’ve bewailed like that myself, too.
We’re all only human.
Buy the rumour, sell the news
Remember, the stock market is a forward-looking prediction machine. It tries to discount the value of what it sees through the mists of time ahead via today’s share prices. It’s doing this all the time.
You’re probably best off not trying to do it better than the millions of smart people and machines that make up the market.
Invest passively, buy index funds, and benefit from their hard work.
But if you must play the crazy game of active investing, stop obsessing over what everyone already knows – or what they think they know.
Think different, and before they do.
You can see this in varying CAPE ratios over time, as investor fear and greed ebbs and flows.