February 28th, 2007

Adjustment of Stock Prices to New Information

I was in graduate school around the time that Eugene Fama was publishing his groundbreaking works on securities pricing and efficient markets. We must have studied in his class a forthcoming article on the The Adjustment of Stock Prices to New Information. He was way ahead of his time and yesterday was a day that proved his theory. In a single day, the market adjusted to some new information and, with electronic trading, almost instantaneously. An amazing statistic: yesterday, only 2 of the S&P 500 stocks were up for the day!

There should be no doubt on any one’s part after yesterday’s 50.33 point (S&P500), or 3.47%, market rout that the overall market’s direction controls more than 50% of any individual stocks action; yesterday it was close to 100%. It didn’t matter about an individual stock’s reported earnings and it didn’t matter about analysts’ upgrades or downgrades.

The economy didn’t collapse yesterday. There wasn’t a catastrophe. The most significant event was that there was a change in expectations and prices adjusted to come in line with those new expectations. In reality, it could have been actually any precipitating “news” factor and the market could have adjusted to that new information instantaneously.

Sentiment and psychology for several weeks said that the market was going to drop ….. and it happened to be yesterday. Some focus on the specific reasons given …. a steep correction brought on by the Chinese authorities on what they considered run-away speculation in their burgeoning stock market and a “troubling U.S. factory report”.

Finding stocks to buy starts with an opinion of the overall condition of the market. There’s no sense in trying to find “stocks that are winners” if the market is in a downtrend. The odds are going to be against you.

And the important question is “where to from here?” My sense is that we should, so far, consider the drop as an aberration, albeit a painful one. As the chart below clearly indicates, no top has yet been formed and there seems to be some time before it becomes necessary to throw in the towel on this bull market leg:

S&P-500 (2006-07)

S&P-500 (2004-07)

The S&P500 index clearly over-extended itself by going about the upper boundary of the channel. Yesterday’s drop brought it exactly to the trendline. It could hover around this level for several weeks until it converges with the 90-day moving average line (blue); by that time it will clearly within the channel. That pattern (lateral movement) will be either the consolidation pattern leading to another leg up or a top.

more on using IBD and Telechart’s TC2007 to follow:

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