Monday, February 9, 2009

The "Buy on the rumor" adage:

What rational explanation can there be for the market to go up by almost 3% on a single day when the big news was a job loss of 598,000, the largest loss reported in several decades? The answer is that there isn't any rational explanation. Isaac Newton once said "I can calculate the motions of heavenly bodies, but not the madness of people." The market is emotional, not rational.

Once again, the old Wall Street adage "Buy on the rumor and sell on the news" seemed to be at work. The rumor was the possibility of the stimulus package being passed. Will the market turn around and move lower once the package becomes a reality? Investors carried out the first part of the adage, and it will be interesting to see if they follow through with the second part.

The adage has its roots from the 1950's when a lot of merger activity was taking place. A study showed that in the few months before a merger was announced (but was rumored), the stock outperformed the market in general, but once the merger was announced, the stock underperformed the market. The best strategy was to buy when the rumor started circulating, and then sell as soon as the news became public.

I could not find any studies that supported the adage since the 50's study, but it has persisted nevertheless. I think it is just something for analysts to pull out when there is absolutely no rational explanation they can think of to explain why the market did something like what it did on Friday. It really doesn't make any rational sense. Once again, we are reminded that the market is primarily an emotional beast rather than a rational thinking intellectually evolved animal.

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