A Look At Investor Psychology Ahead Of Important Events

At times, the stock market can react so surprisingly that price action seems random or even rigged. A stock can sell off following an earnings beat or the market can rip higher following a rise in unemployment rates. But before investors throw up their arms and give up on understanding why the market reacts the way it does, it’s important to understand the psychology behind market catalysts.

The first thing a trader should know ahead of an important announcement — such as a monthly same-store sales report, a Federal Reserve interest rate decision or even a company’s quarterly earnings report — is that the number itself is likely not the biggest factor in how the market reacts. Instead, the consensus market expectations are the most important factor.

Say Company A reports EPS of $1 and Company B reports an EPS loss of $1, but Company A’s stock falls 2 percent and Company B’s stock rises 2 percent. Obviously a company that is profitable makes for a better long-term investment than a company that is losing money, but clearly there is more at play here. The most likely scenario is that Company A missed its own guidance, consensus analyst estimates and/or, most importantly, the consensus “whisper number” that investors had been expecting. In other words, the market was expecting something more out of Company A than it got.

Trading Is About Anticipating Surprises

In that sense, stocks tend to react to big numbers only if they are a surprise. Markets rarely react strongly to Federal Reserve interest rate changes because the Fed deliberately tries not to disturb financial markets by being as predictable as possible. Prior to the latest Fed interest rate hike announcement in March, the bond market had already priced in a greater than 90-percent chance of a 0.25-percent hike.

The stock market is typically considered to be forward-looking. In other words, at any given time, stock prices reflect expectations for the future rather than current or past market conditions. Therefore, another key consideration for investors is how share price has changed prior to the upcoming event.

Take Company B in the previous example. If consensus analyst expectations were a $1 EPS loss, but the stock was down 10 percent in the month leading up to its earnings report, it’s fair to say that the market was pricing in a much worse number than a $1 loss. It’s also likely that investors who placed bearish short bets against Company B will move on from their trade once the earnings report is released and cover their short position, adding to the buying volume that is driving the stock higher following the earnings report. 

Be Prepared

Prior to any market-moving event such as an earnings report or data update, it’s always important to ask the following questions before making a trade:

• What do other investors expect to happen?
• How has that expectation already shifted the market prior to the event?
• How could the event change investors’ opinions?
• How are investors likely to react once their opinions have been changed or reinforced?

Once you have answered those questions, you have shifted your focus away from the event itself and toward the traders that will actually be moving the market with their buying and selling following the event, a much more relevant place to focus your attention.

Sure, the number itself may be the catalyst, but it’s how investors react to the number that creates the trading opportunities.

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