Thursday, July 11, 2013

Price discounts the news

Over the years, I've developed and used an investment process that effectively combines fundamental and quantitative research with technical analysis. It can be a tricky endeavor but in my experience, when properly bringing together the three disciplines, one is able to leverage their power synergistically and achieve a 1+1+1=5 outcome. Very powerful.

However, of the three disciplines, it never fails that I get the most push back and skeptical questions when it comes to my use of technical analysis (TA). In just the last five years, thanks in large part to hedge funds, TA has made huge strides with regards to its acceptance as an alpha generator and reducer of risk. Yet naysayers and cynics remain, in droves. This despite an increasing number of academic studies showing otherwise, that TA is indeed a beneficial additive to one's investment process.

I used to engage in such debates, going back and forth with professional friends and colleagues about the merit of TA, but I've learned to temper that impulse. That's not to say I don't freely give my reasons for employing TA in my process, but rather I only spend so much time on the discussion before moving on. In this business, some are open to listening and learning new ideas that could possibly help in their efforts to beat benchmarks and put up numbers, whereas others are much more set in their ways and view the investing world more narrowly, as they choose to see it. And that's completely fine with me! Different strokes for different folks, that's what makes markets, and all those other cliches and sayings....

On several occasions, I've written here about how price tends to lead the news. Unlike TA in general, I believe this tendency is more commonly accepted by investment folks, with any debate likely coming down to the length of lead time. Do prices discount the news by 6-9 months -- a frequently cited period -- or is it just days, hours, or minutes? I'm not about to settle that issue, but I will show some examples.

One of my favorites is the Egyptian ETF (EGPT) in 2011.

Source: Bloomberg

EGPT had been in a very nice uptrend heading into 2011. But then about mid-January the ETF gapped down, breaking its ascending trend line. Several days later, riots erupted in Egypt and the ETF gapped down again. Needless to say, price seemingly reacted before the news, giving investors 5-6 days to assess what to do before the actual riots and unrest occurred. The first gap-down was a meaningful -8% decline, but the second gap-down was much more painful at about -15%. Also, note the first gap-down was on slightly-elevated volume, inferring some EGPT holders appeared to know something was askew and wanted out. Compare this to the volume spike during the actual event, when everyone then knew the news and rushed for the exits. Price can often be very telling, and this is just one of many examples I've observed over time.

Another example is well-documented in academic circles and it involves price action around earnings surprises.

Source: Aswath Damodaran

The chart above shows price returns above or below benchmark (excess returns) for eventual earnings surprises. I drew a vertical red line on the day of the earnings announcement (Day 0). The key takeaway is price tends to do a very good job at discounting earnings surprises. It's not perfect but the distribution of returns in the above chart is fairly monotonic, meaning the excess returns roughly align with their respective earnings surprise deciles. The most positive earnings surprise decile had the largest positive pre-announcement excess return and the most negative earnings surprise decile had the largest negative pre-announcement excess return, with the other deciles more or less falling in line. In other words, price doesn't just discount news, it also does a pretty good job at getting the extent or degree of discounting correct. 

A more obvious conclusion to be drawn from the chart is much less alpha is to be gained after the earnings announcement than before. Referring to just the most positive decile, an almost 8% excess return is produced prior to the earnings announcement with about 2% of excess return resulting after the fact. Granted, 2% alpha in about 50-60 days is nothing to dismiss, no argument there, but my larger point is by far the bulk of excess returns are attained pre-announcement of the news. 

Yes, wouldn't it be nice if we could see the future and thus capture these massive pre-announcement excess return spreads. Sure, but as I've been discussing, apart from owning a crystal ball, price may be the next best thing when it comes to offering some hints about what lies ahead.

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