Eugene Fama’s Efficient Market Theory (EMT) taught us that when news is released, it’s immediately priced into stocks.
But that’s impossible because it never took into consideration the friction of news flow.
If you have an intended reach of 100 people, and only 30 of them get the news, the other 70 people haven’t had an opportunity to react.
Once they do, though, there’s further reaction.
“Nothing beats the stock market for sheer frequency of potentially interesting news items,” said Robert Shiller in Irrational Exuberance. News can foster an attention cascade among investors, he says, sending them into herd like behaviors. Following good news and rallies, we may often see positive feedback loops, where investors rush in thinking they missed a run, the media fuels the fire more, more investors move in, the media presses the issue harder. We see it all the time.
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Then there’s reaction to the reaction and so on and so forth.
While the EMT held some weight years back, today is does not. In fact, we’ve disproven it.
We can actually trade three phases of the news because of information friction, or the delay in the dissemination of news to a greater number of investors through electronic media. Sometimes the news or rumor we pick up on won't be fully disseminated, meaning the intended audience won't get it until later in the day when they get home from work.
Three Phases of News Flow
Phase 1 -- Anticipation of News Effect
Stand at the top of a snowy hill with a small snowball.
Now, begin to roll it down the hill. As you do, it begins to become bigger and bigger. It begins to build momentum. Well, the same thing happens with stocks.
If we can spot a potential story ahead of the herd, we can take a position and wait. We can get a jumpstart with our snowball. Then, as they begin to wake up to opportunity, our snowball gets bigger and bigger and picks up momentum.
Phase 2 -- Dissemination of News -- Stone in Pond Effect
We’re often told that news is immediately priced into a stock upon release.
But I’ve proven that theory to be old, and false especially with information friction. As news goes from local to regional to national to global in some cases. Until that wave of news dies off, the impact on stocks can be longer lasting, and not immediately priced in.
Throw a stone in a pond. Notice the ripple. That’s how new dissemination works until the ripples fade and die into nothing.
Look at marijuana stocks for example. On anticipation of legalization in Canada, pot stocks exploded. Each and every one ran higher on the anticipation and dissemination of that news.
The Death of News: The Rubber Band Effect
Remember how marijuana stocks exploded on Canada’s news of legalization?
Well, now the news is out. So, naturally, we’ll see a sell the news reaction. This is something that should have been expected all along. Not because pot stocks are weak, but because this is how news and the market work.
This happens to every single stock out there impacted by news flow.
While pot stocks did pull back on death of news, wait for the weak hands to leave. Then buy, hold, wait a bit, and cash out when related stocks take off on more positive news.
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