Can you trade on rumors? One possible model
In Tradestream, I spent a whole chapter looking under the covers of investing/trading strategies that focus on rumors. Greater sentiment analysis (like the hubbub that erupted after Prof. Bollen published a paper on using twitter to predict stock market swings) is in early days but at its core is a desire to use news/chatter to better gauge future stock moves. Bold and audacious, but not nearly there yet.
Rumors: A ModelIn the book, I developed a model upon the one Cass Sunstein (co-author of Nudge and just a prolific writer/thinker) used in his most recent book, On Rumors: How Falsehoods Spread, Why we Believe Them, What Can Be Done.
Rumor transmission often involved the rational processing of information, in a way that leads people quite sensibly in light of their existing knowledge, to believe and spread falsehoods. This problem is especially acute on the Internet -- Cass Sunstein, "She Said What? He Did That? Believing False Rumors," Harvard Law School Public Law Working Paper No. 08-56 (November 2008), 2Sunstein describes a useful framework with which to understand how rumors get started and how they get propagated -- influencing decision making. Sunstein describes the various actors in the social transmission of false information. While he focuses on rumormongering, I try to apply this framework to investing.
- self-interested, varying degrees: they may own a stock and work to discredit those who don't like it or are short
- altruistic: sincerely interested in promoting some type of cause -- these guys don't even realize that they are spreading falsehoods
- Priors: success or failure of rumors depends on how closely they approximate the prior beliefs of those who hear them
- motivations: people don't enjoy hearing bad things about ideas/people close to them and conversely, they are more open to receiving false info about something they dislike
- beliefs: Sunstein says that people who have strong prior beliefs usually do so because of what they know and therefore, require a lot of supporting information to upseat those beliefs
- Cascades: the mechanisms of rumor transmission, why/how/when people accept/reject a rumor is intimately connected to how the information affects their personal desires
- informational: groups of investors are led to accept a thesis in spite of individuals' private info. Think of all the hating that goes on on Yahoo Message Boards.
- reputational: people can be led to believe things in conflict with their priors but do so to curry favor with others. This is equivalent to a fund manager on CNBC pumping his portfolio -- as an expert -- his status and street cred influence others' beliefs (whether correct or not)
Rumors and Preannouncement TradingI chose to focus on rumors surrounding M&A announcements. Many times, the Wall Street Journal will publish stories on unsubstantiated mergers and acquisitions. Target stocks will jump and acquirer stocks drop. That said, though, many of these rumored M&As fail to consummate.
"While sellers lose money when a rumor precedes an actual announcement, in most cases rumors fail to materialize into public announcements." Rumors and Pre-Announcement Trading: Why Sell Target Stocks Before Acquisition Announcements?" (Gao, Oler)Given the research of Gao and Oler:
On average, stock prices of rumored firms drift down to their pre-rumor level over a 70-day period after the initial price jump when a rumor is published and that only 12% of rumored takeovers materialize into actual announcements within 70 days.So, really, Tradestreaming would be all about finding the right side of this strategy -- where the numbers, data and probability is with the investor. That would mean taking the other side of the trade.
The Antitakeover Strategy
- Research WSJ for reported but unsubstantiated M&A
- Remove all mega cap firms (<$20B)
- Short a basket of rumored acquisition targets and hold 70 days after the rumor first appeared. You can hedge by going long the market if you like.
- Strategy performs even better during periods of increased M&A activity