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Buy the Rumor, Sell the News: Why Stocks Drop on Good News
By the morning of the announcement, the good result has already been paid for. Everyone who paid for it now holds what they were waiting for, and they turn into the sellers.
A company reports a quarter that beats every estimate on the street, raises its guidance for the year, and then watches its own stock fall 6% in the first minutes of the open. To a newcomer this looks broken. To anyone who has sat through a few earnings seasons it is entirely familiar, and the phrase they reach for is among the oldest in the business.
Explaining it to somebody outside markets tends to produce the same reply: the company did well and the shareholders are cross about it. That is not far off, and it is a better summary than most of what follows.
What is being priced
A share price records almost nothing about what has happened. What it carries is the market’s running estimate of what will happen, revised continuously and in public, which means that when a good result is widely anticipated the anticipation itself gets bought in the weeks beforehand and the price climbs to reflect a result that does not yet exist, which is why a long run-up into an announcement can look like somebody knowing something when it is only a crowd agreeing with itself.
So by the morning of the announcement, the good news has been paid for. The release either confirms what was already assumed, which changes nothing at all, or it falls a little short of the whispered number, which is bad news in good news’s clothing. Either way the holders now have the thing they were waiting for. They have no particular reason to keep holding it, and anyone who might have bought on the headline finds the headline already in the price. Buyers turn into sellers. The sellers find few takers.
The comparison that decides the move is better or worse than what the price had already assumed. Good and bad hardly matter. A beat that arrives smaller than the market had quietly settled on is, for pricing purposes, a miss, and it trades like one.
The same mechanism in reverse
Run it the other way. A stock that has slid for weeks into a report everybody expects to be dreadful can rally on dreadful numbers, because the selling was done in advance: the report confirms a disaster that is already in the price, the nervous holders left some time ago, and the simple absence of fresh sellers is enough to lift it. Sell the rumour, buy the news, as nobody quite says. The pattern turns up about as often as the famous one.
Reading the run-up
Most of what you need sits on the chart before the event. A stock that has climbed sharply into earnings on rising volume, with analysts revising upward and the story appearing in places it does not normally appear, is carrying a great deal of expectation, and the bar the result has to clear has moved up along with it. A stock drifting lower into the same report on thin volume carries very little. The bar is low, and a thoroughly ordinary result can clear it.
This is one reason the earnings date check earns its place well beyond gap protection. It also indicates which way a surprise is the more likely to run.
An illustration
Picture a trader who holds through a report by accident, having never checked the date, and who then watches the company beat comfortably while the stock falls anyway. The first response is to read the release again, hunting for the bad part. There is no bad part. What had gone unexamined was the chart on the way in: up by nearly a fifth in three weeks, carried along on a run of upgrades. The beat came in at the size everyone had already agreed on. Hence the fall. The only surprise in the room belonged to the trader.
Trading around it
- Before any scheduled event, look at what the stock has done going into it. A large run-up means expectations are high and the result has to clear them. A decline means the opposite.
- Do not buy good news on the day of it. Where the story genuinely improves the business, the chart will offer a level later on, once the transfer from anticipators to latecomers has finished.
- Holding into an event means sizing for the gap, and it is worth remembering that the direction of that gap depends on expectations the press release will never state.
- When a stock rises on bad news, or falls on good, treat the move as information about positioning. The market is telling you who was already in.
News you hear late is priced in comes at the same idea from the other end, where by the time information reaches most people its effect on the price is behind it.
Frequently asked questions
Why do stocks fall on good earnings?
Because the good result had already been anticipated and bought in the weeks leading up to the report. The announcement confirms what the price had assumed, the people who bought the anticipation finally have what they were waiting for and take their profit, and anyone who might otherwise buy on the news discovers it is already in the price.
How can I tell what the market expects before an announcement?
Look at what the stock did on the way in. A sharp run-up on rising volume with upgrades arriving from every direction means expectations are high and the result now has to clear a bar that has moved. A drift lower on light volume means the bar is low. The chart carries the expectation that the press release will never mention.