Chapter 3News and Stock Prices

Something very unusual happened at the market peak of October 2007 as the market was about to begin its seventeen-month decline. We believe what happened taught a generation of investors an unproductive lesson, especially baby boomers who are more and more interested in capital preservation. They learned to sell stocks on the slightest bit of bad news and to believe bad news predicted a bear market. This behavior did not serve them well during the post 2009 bull market. As there was a fair amount of occasional bad news the whole way up the multiyear bull market, we believe investors incorrectly reacted to it. Before examining that, let's look at the normal relationship between news and stock prices.

For many decades, the format of the front page of the Wall Street Journal hasn't changed. There are one or two sentences of introduction to articles that appear on various pages throughout the paper. Research in the mid-1970s rated those first five blurbs as to whether they were good or bad for business, good getting a plus 1, bad getting a negative 1. The score could range from plus 5 if all five articles were good for business to negative 5 if all five articles were bad for business. They compared the news quality to subsequent stock returns. Jumping to the summary, they found that investors should buy stocks when the news is bad and sell stocks when the news is good.

Figure 3.1 Hypothetical Stock Market and Economy

Here it is schematically ...

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