Trade the News: Why Markets Are Not Efficient After All

January 31, 2019, By fierceinvestor,

Eugene Fama’s Efficient Market Theory argues that when news is released, it’s immediately reflected in the price of a stock.

“The accepted view was that when information arises, the news spreads very quickly and is incorporated into the prices of securities without delay,” as reported by a Princeton University paper, The Efficient Market Hypothesis and Its Critics.

Fama believed the market was efficient.

In other words, he felt that markets efficiently and instantaneously process new information.

But he’s laughably wrong. He ignores information friction, or the delay in the dissemination of news to a greater number of investors.

Not every one receives news at the same time.

The markets are not efficient after all.

“The market could still be absorbing or reacting to news releases hours, if not days, after they are released. The study found that the effect on returns generally occurs in the first or second day, but the impact does seem to linger until the fourth day,” as reported by the Journal of International Money and Finance (2004).

Efficient market theory has also been disproved by the following studies:

“I examine returns to a subset of stocks after public news about them is released. I compare them to other stocks with similar monthly returns, but no identifiable public news. There is a major difference between return patterns for the two sets. I find evidence of post-news drift, which supports the idea that investors under-react to information [ . . . ] There is a large amount of evidence that stock prices are predictable.” 
—Wesley S. Chan, M.I.T., Stock Price Reaction to New and No-News: Drift and Reversal after Headlines

“Arguably, the most important process affecting price movements is the news arrival process. For example, in Ross (1989) the volatility of stock price changes is directly related to the rate of flow of information to the market [ . . . ] On days no news arrives, trading is slow and price movements are small. When new information arrives that results in a change in expectations, trading becomes vigorous and the price moves in response to the impact of the news [ . . . ] In addition to price movements, news arrivals can affect the time between trades, number of transactions, and volume of trade.” 
—John H. Maheu, University of Alberta, and Thomas H. McCurdy, University of Toronto, News Arrival, Jump Dynamics and Volatility Components for Individual Stock Returns

“Periods of good news are followed by periods of unusually high returns relative to natural benchmarks, with the reverse for bad news [ . . . ] Post-event drift is the tendency of individual stocks’ performances following major corporate news events to persist for long periods in the same direction as the return over a short window—usually one to three days—encompassing the news announcement itself.” 
—Andrew Jackson and Timothy Johnson, Unifying Under-reaction Anomalies

Stocks gradually price in news events. To argue for efficient market means traders have to be efficient, reacting all at once at the same time.

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