Does the news really drive the markets?

We all read the various media sources which propagate news stories about the economy. The pundits have no difficulty in explaining what an increase in GDP means, or a tapering of QE by the Fed, or the China real estate bust.

Acres of newsprint are devoted to such coverage. Many forecasts are made on this basis.

Perhaps that is why several members of the Trade for Profit Academy are puzzled by my claim that the news does not drive the markets. Well this week there was yet another example of why this is true, so I thought I would explain what I mean.

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We all love a good story especially if it reinforces our views

So, from the beginning we are all conditioned to believe that if we can get a handle on the economic data and follow a good story, we can invest wisely. It's a given that the news and data drive the markets.

Of course, human nature takes over very early in our investing/trading career, and most of us are excited by which particular shares are in the news right now. After all, these headline-grabbing shares are moving, and who wants to invest in something that just lies there, unmoving and unloved? That ties up capital. The hot shares are where the action is!

This means that most of us are primed to trade off the barrage of exciting economic reports that relentlessly bombard the marketplace.

In fact, to encourage this approach, most spread betting companies issue alerts such as: "What will the US GDP number be? Make your bet now!" All of this reinforces the view that the news makes the markets.

But we have all seen situations where an important economic report, which was first seen as bullish, produced a sharp decline instead (and vice versa). That seems perverse, so what is going on here?

Here's how the market reacts to news

If you knew nothing about the markets, what would you expect the stock market to do at the release? Of course, it should drop; probably very hard.

Here is the hourly chart:

Just before the release, the market dipped below the 16,800 level. But on release, despite the negative number, the market rallied 100 points!

If the market was acting rationally that should not have occurred.

But after that flurry of buying, the market resumed its downtrend, which was already established from the Monday high.

The sell the rumour, buy the news' effect

An economic report does not exist in a vacuum. Some traders will view it as bullish, some as bearish and some as neutral. What seems obviously bullish to you (and/or the pundits), may be viewed by many as disappointing and they may sell, perhaps heavily.

Yes, closely-watched reports may produce a sharp increase in volatility around the time of the report (see chart), but it is rare for a report to suddenly change a trend that is in operation already.

This increased volatility may trigger your stop if it is very close, and that is unfortunate.

The chart shows the sell the rumour, buy the news' effect, where some traders will note the bearish talk before an important report and that is accompanying a decline. On release, no matter what the report says, they will take their profits by covering their shorts. This could swamp the selling and the market will rally.

Gloom and doom sell stories

Gloom sells in this environment. It is a great story, which many believe because they are feeling gloomy themselves. Remember March 2009? That was when the world was about to end, banks would go belly-up, and the dollar was doomed. That was the low in stocks and there were few bulls.

And as the market rallies and climbs that wall of worry, more pundits will come out with even more bullish forecasts, emboldened by the previous market action. Suddenly, every news item has a bullish slant. Negative reports are brushed aside. This attracts more bulls until at the top, the bullish enthusiasm is loudest. There, you will find few prominent mainstream pundits expressing a very bearish view. And the process repeats on the way down.

In a strong rally, such as we have seen in stocks since 2009, negative news is shaken off, and bullish news is greeted with glee. If that same negative news was released into a bear market, you can be sure it would be greeted by heavy selling, not buying.

In markets, context is king.

Why swing traders should follow the news

In swing trading, we are looking for a low-risk opportunity to follow the market's path of least resistance. And this path is often working against the obvious' interpretation of the current economic data. The charts hold the information we need.

My advice to swing traders is this: yes, follow the news but only to gauge the level of sentiment out there. Do not be seduced into taking a hard-line stance one way or the other. You are looking to surprise the market, and that usually means trading against mainstream opinion and perhaps your own.