Why Good Things Sometimes Happen After Bad News

One of the secrets to being a successful investor is the ability to keep your head during a bear market while everyone else around you is losing theirs. To do that, you have to understand that bad news doesn’t necessarily mean stock prices will fall.

While this may sound strange, it’s important to understand that whether news is good or bad is totally irrelevant to stock prices. Failing to grasp this basic truth causes investors to become overenthusiastic when news is good, and panic when news is bad. To be a successful investor, you need to understand that what really matters is whether the news is better or worse than what was already expected.

The market price already reflects all publicly available information. When the market is down because the news has been bad, the market can be expected to keep falling only if future news is worse than anticipated. But if future news is no worse than expected, you’ll earn high returns resulting from low valuations. And even if future news is not good, but it’s still better than expected, valuations will rise as the risk premium demanded by the market begins to fall. That’s often how bull markets begin.

The latter scenario is exactly what happened after March 2009. In general, news on the economy since March 2009 hasn’t been very good. We’ve had the weakest recovery of the post-war era. But we also didn’t get the second Great Depression that many had feared and even predicted. So, the market has improved, albeit slowly, not because economic news has been great but because it has been better than many expected.

The following illustration is another great example of why it isn’t the news itself that matters, but whether that news comes as a surprise.

For the commercial real estate industry, 2010 was miserable as mortgage defaults multiplied. In 2008, just 1 percent of commercial loans were delinquent. In 2009, the default rate jumped to 6 percent, and in 2010 it rose again to 9 percent.

Given that horrible news, you might have expected that investors in commercial mortgages would suffer greatly. You might also have expected that investors in equity investments in real estate (REITs) would suffer as well.

Yet despite the dramatic increase in defaults, 2010 was a great year for investors in commercial mortgages as prices soared. Junior AAA-rated bonds went from 30 cents on the dollar to almost par (or 100 cents on the dollar), and equity investors enjoyed the more than a 28 percent rise in the Dow Jones U.S. Select REIT index.

The contrast in this case between the growing default rate, rising value of commercial mortgages and the great returns on REITs seems contradictory at first. The explanation is that prices rose because the default rates, while bad, weren’t nearly as bad as the market had been expecting.

The following historical examples from my first book, “The Only Guide to a Winning Investment Strategy You’ll Ever Need,” will help you learn how to think about good and bad news.

Good news, bad results

On February 4, 1997, after the market had closed, Cisco Systems (CSCO) reported that its second-quarter earnings had risen from 31 cents per share in the prior-year period to 51 cents, an increase of 65 percent. Certainly, no one would suggest that a rise in earnings of that magnitude is bad news. Yet, Cisco’s stock price fell the following day from its prior close of just over $67 to $63, a drop of 6 percent. The market’s reaction to what otherwise seems like good news reflects that investors were anticipating a greater increase in earnings than Cisco reported.

Bad news, good results

A similar phenomenon occurs when a company’s stock price rises after a “bad” earnings report. For example, the day IBM (IBM) released its earnings for the second quarter of 1996, its stock price rose 13 percent. Based on that, one would have thought IBM had announced spectacular results. However, its earnings were down about 20 percent from the same period of the prior year. The stock rose because the market was expecting IBM to announce far worse results.

The bottom line is this: If you want to be a successful investor, you must understand that surprises are a major determinant of stock performance, and by definition surprises are unpredictable. It’s also important to note that happy surprises are just as likely as unhappy ones. In the end, you’re best served by ignoring the news altogether because acting on it is likely to prove counterproductive.

This commentary originally appeared June 18 on CBSNews.com.

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