Every investor has been lured in by a head fake. That is defined as a period when the market significantly changes direction away from an ongoing trend. These head fakes can be sudden and hard to predict. But in some cases, you can prepare yourself if you know what to look for. Before talking about how to invest in these periods of volatility let’s take a look at three reasons why head fakes occur.
Markets are forward-looking
An important thing to remember about the markets is that what you see at any given moment is the market’s interpretation of where a security is going to go. You’ll hear the phrase company XYZ’s positive earnings were already “baked into” its stock price.
We are on the cusp of a new earnings season. This is the time of year when publicly traded companies announce their quarterly financial results. Analysts and investors pay particular attention to a company’s top-line number (i.e. its revenue) and its bottom line number (i.e. earnings per share or EPS).
But if you pay attention to a company’s stock before their earnings announcement, you can usually get a sense of what analysts are expecting. If the stock starts moving up in advance of the earnings report it is usually a sign that the market is expecting a positive earnings report. Conversely, if the stock is going down, it is a sign that the market is expecting a negative earnings report.
So if analysts are expecting one result and get another, a security may change direction quickly. You also see this frequently with commodity prices. Oil prices and the stock price of oil companies can fluctuate significantly during hurricane season. If a storm is expected to disrupt oil production, prices will spike. However, if the storm weakens or changes track entirely, the prices could reverse just as fast.
Markets hate uncertainty
Market head fakes due to future events are somewhat easy to predict. The ones that aren’t can happen on a day when a single Tweet or bit of economic data changes or challenges an investor’s interpretation. You saw this earlier this year when a “good” jobs report sent the market plunging because investors took it as a sign that the Federal Reserve might not lower interest rates.
You also see it in the ongoing trade war with China. Just a rumor that there are talks or a lessening of tensions sends the markets rising. And when we hear reports of retaliatory tariffs the market goes the other way. That’s why you can see the market rise and fall by hundreds of points in a single trading session.
This is because when new data comes in quickly and unexpectedly, the market needs time to evaluate the new data. In the meantime, the “animal spirits” of the market can take over. When emotion takes over the market, it can start to move irrationally in one direction or another. That brings us to our third point.
Markets are always looking for equilibrium
The biggest reason why we have head fakes is that markets don’t move in one direction all the time. Even in the midst of this historic bull market, there have been times when the market has had bad weeks and even months. Just look at 2018. First, there was the tech stock crash in the summer. In December, the entire market was dragged down. Speculative sectors like cryptocurrencies and marijuana stocks saw their bubbles burst. And all of this is due, in part, to a market that got ahead of itself. The simple fact is that sometimes markets have to go down before they can sustain future gains.
How to invest regardless of the market direction
The best advice is to avoid engaging in market timing. All too frequently, investors look for tops and bottoms only to find that they were fighting a trend. Technical indicators for levels of support and resistance can be useful and are frequently accurate. But if you’re looking to hold a security for a long time, the sound advice is to ignore the noise and the headlines surrounding a stock.
Good stocks don’t suddenly become bad. If you liked the stock at $40 a share, you can still like it at $32 a share and pick up additional shares at a discount. Conversely, bad stocks don’t suddenly become good. If you were avoiding a stock at $20 a share, it’s probably best to avoid it at $25 a share.
The caveat to this rule is if something has fundamentally changed that impacts your feelings about the security. And by fundamental, I mean something that is a real game-changer. For example, if a company introduces a key innovation that gives it a decisive advantage over competitors. Or a favorable legislative or judicial outcome that clears up an obstacle to growth. For example, marijuana stocks are unlikely to make the major move that investors hope for until and unless full legalization is achieved at both the federal and state level in the United States.
Head fakes in the market are a common occurrence. Keeping your wits about you and performing a regular, thoughtful analysis of your portfolio and investment objectives can keep you from over-reacting to any single piece of news.