How to understand impact of events on markets

Recently (as expected) a lot of investors and advisors I meet, want to discuss views on the upcoming general elections in India in April 2024. While discussions involving politics can become long and perhaps loud, I offer a small write up on exploring the old adage in the market which goes like this, “Buy on rumours, sell on news”.

There are many important events that have a preannounced date that is declared days or months or even years before the actual event. Events like the National election, Union Budget, Monetary Policy, Fiscal Stimulus announcements, important Economic Data releases etc. create a buzz among investors and in the media. On a company specific level, these events can be in the form of earnings announcement, product launches etc. People try to anticipate the outcomes of these events and also the impact of the same on the stock prices. However, when events unfold as expected i.e. the consensus predicted the outcome correctly, the markets do not behave as anticipated. And hence the logic of “Buy on rumors, sell on news”.

Believe it or not, despite the absence of so many meetings/events in the seventeenth century, Joseph De La Vega had written about this behavior of markets in his famous book, ‘Confusion de Confusiones’ in 1688. In the book he writes, “The expectation of an event creates a much deeper impression upon the exchange than the event itself. When large dividends or rich imports are expected, shares will rise in price; but if the expectation becomes a reality, the shares often fall”. He calls this behavior of stock prices quite natural and explains it logically using the observed behavioral characteristics of both types of investors, the Bulls and the Bears.

Whenever there is an event where the consensus is expecting a positive outcome, the Bears would generally refrain from getting in the way. The Bulls become quite optimistic with the state of affairs, and the prospects of gains will drive them to buy more. They become overconfident and any small negative development on the way to the event doesn’t deter them from their path (Climbing the wall of worry perhaps). “But as soon as the ships arrive or the dividends are declared, the sellers take new courage. They calculate that for some months the purchasers — the bulls — will not be able to expect very propitious (new) events”, says De La Vega. With nothing to look forward to for some time, the Bulls either take profits or stop their additional purchases. The Bears start selling based on the excesses that were created on the way to the event. “…and therefore, no wonder that the shares fall, because they are abandoned by the one side and are attacked by the other”.

Coming to more recent research on this topic, a research paper by Richard Peterson, highlights that “Anticipation of reward generates a positive affect state. Positive affect motivates both increased risk-taking and increased purchasing behaviors.” Rising prices reinforce the trend and investors downplay the risks. As we move towards the event, ‘Myopic Discounting’ comes into effect. It refers to the tendency to prefer near term rewards over longer term. “As the anticipated potential reward approaches in time, investors’ positive affect is increasingly aroused”, says Peterson. By the time, the event date is reached, much of the upside from the outcome that the consensus is expecting, gets exhausted. With nothing to look forward to immediately, the profit booking sets in; risk taking moves to risk aversion. Price fall confirms the change in trend and starts reinforcing downward move.