How investors can profit when markets overreact

When markets overreact to news, investors should consider the resulting opportunity to profit.

Read: The challenge of resolutions and behavioural biases

A market insight report from Richardson GMP explains that “there is not one simple rule on when to take advantage of overreactions, but there are some scenarios that appear profitable and worth considering.”

Specifically, the report looks at instances where individual companies change value abruptly. Related biases include recency bias, focusing effect and availability heuristic, all of which can apply to company-specific events or general market events.

Here are definitions based on the report:

• recency bias—tendency to focus on a recent event and jump to the conclusion that the trend will continue
• focusing effect—tendency to overemphasize one aspect of an event, such as earnings in a single quarter
• availability heuristic—mental shortcut whereby inferences are drawn from past events, such as when an earnings miss results in an investor recalling the failures of other companies

The report goes on to look at S&P 500 firms, first analyzing all instances when individual companies had at least a +/-3% move on a given day.

Richardson GMP finds that the market successfully adjusts to minor price changes up or down, defined as +3% to +5%, or -3% to -5%.

However, if news is triggered by a share price change greater than +5% or less than -5%, the market responds less quickly and accurately.

“On big misses, the share price seems to overreact to the downside and makes up some of this lost ground over the next few months,” says the report. “On big positive surprises, the market does not seem to adjust enough, as these companies on average continue to outperform the market.”

The firm also finds that trend is key when forecasting how companies perform following big price moves.

“Trend is your friend,” says the report, describing the phenomenon that companies in an established uptrend (as measured by the slope of their 50-day moving averages) show strong positive absolute and relative performance following a big downward surprise.

In contrast, companies in an established downtrend that enjoy a positive surprise tend to give some of those gains back on a relative basis.

From a trading perspective, “it would seem that big price drops often see a good degree of price recovery over the subsequent months,” summarizes the report. “And this is more evident if the share price had been in a previous uptrend before the big miss or negative news event.”

In other words, “don’t fight the original trend,” says the report.

For full details, read the full Richardson GMP report.

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