Front-Running the Pre-Earnings Sell-Off

Let’s accept that attempts to analyze the short-term fluctuations of the stock market are futile, because they try to reduce an incredibly complex set of causes and effects to one or two simple answers. But let’s also admit that a lot of people are wondering right now: Why would the Dow fall 191 and the Nasdaq 98 points in a single day? So take this as a futile, but well-intentioned, attempt to do some reducing.

One of the hoariest clichés on Wall Street is “Buy the rumor, sell the news.” It’s a cliché, but (or perhaps because) it captures something important about markets, which is that they are fundamentally forward-looking. In theory, although not always in practice, what a company did last quarter is immaterial to its current value, except insofar as its recent performance gives you some sense of what its future will look like. So you buy the rumor, which tells you what will happen (ideally), and sell the news, because it tells you what has happened.

Earnings reports, which are flooding the market this week, are one of the occasions when you can see this rule obeyed. Often stocks will enjoy tremendous run-ups in advance of their earnings reports, only to sell off once the report actually occurs. And this often happens even if companies beat expectations, and sometimes (though more rarely) even if companies paint remarkably rosy scenarios of the quarters ahead. The point is that the most excellent performance has already been priced into the stock, so there’s nowhere for it to go in the short term. Look at what shares of Microsoft (which I own shares in) have done since announcing blowout earnings yesterday, or the similar drop in IBM. Some companies, like Lucent, saw their shares sell off today despite huge earnings increases because they suggested that the next couple of quarters might not be as strong. But in general the selling on good news was fairly consistent.

That much is fairly obvious. What perhaps isn’t quite as obvious is that what the market considers “news” as opposed to “rumor” appears to be changing. In other words, instead of waiting for the actual earnings report to sell off, investors seem to be treating the report itself as a kind of given, and selling off in advance of it. Look at the Internet sector, and at a company like, which reports earnings tomorrow. Its stock had a sharp run-up in the past few weeks, rising more than 30 percent, but in the past two days it’s tumbled, even though the “news” has yet to arrive.

The truth is that this makes perfect sense. Companies now do such a good job of managing earnings, and of making sure analysts have reasonable expectations, and analysts themselves tend to be such creatures of the herd, that huge earnings surprises are relatively rare. And with prices as rich as they are, it would have to be a really huge surprise to send a stock skyrocketing. Given all that, treating the earnings report as a foregone conclusion is understandable. The sell-offs that traditionally occurred after earnings came out, then, are happening before.

This doesn’t happen in all cases (Microsoft’s shares sold off only mildly before its report), and there are no long-term consequences to the sell-offs. (Companies that report excellent earnings growth and excellent prospects eventually see their stocks rise.) But it does suggest that the market is becoming increasingly efficient, in the sense that it’s becoming increasingly faster at processing information. It also shows why the market eventually eradicates any simple rule of thumb that seems to offer the chance at easy profits. Once enough people recognize that sell-offs are occurring after earnings, they start to front-run that sell-off, and then other investors try to front-run the front-runners. Who knows? Eventually maybe we’ll do away with the pre-earnings run-up entirely.