March has been quite a month, filled with steep ups and downs. At this point, we are all aware of the catalyst: the Iranian attacks/war and accompanying headlines. There has been a lot of turmoil in the past few weeks that hit the headlines. This may have been too much for investors attempting to boil down potential outcomes of these on-again, off-again headlines, subjecting the stock market to some wild swings.
The breakneck speed between an announcement and the stock market reaction was mesmerizing. The stock market was influenced more by the headline rather than the actual impact. In fact, companies’ earnings do not respond to any obstacles within minutes of being broadcast. Though not normal, it is not uncommon either for stocks to react to headlines in such a sporadic fashion. This is referred to as headline risk.
Headline risk is the possibility that a news story will adversely affect the price of an investment, such as a stock or commodity. Headline risk is mostly associated with individual stocks but can impact sectors more broadly or, on occasion, the entire stock market.
Suppose a pharmaceutical company announced a breakthrough drug that can cure cancer. What cancer patient wouldn’t want such a drug?!? In response, the pharmaceutical company’s stock would soar as investors would flock to buy the stock in the hopes of “getting in” on the forthcoming earnings. Likewise, if the FDA drug trials determined the drug to be ineffective, the stock would plummet. Irrespective of the underlying financials or fundamentals, the stock would move based on the news.
This happens because equity investors are quick to guess at extreme possible outcomes without evaluating probable impacts or a reasonable time horizon. Headlines generated by newspapers, television, or online have a wider impact, potentially moving the entirety of the stock market. Note that prices can move even if the story is incorrect or misleading, although in such cases, the prices will tend to snap back.
Such environments can be tricky and harrowing. Tricky from an investment standpoint, attempting to assess what is reasonable vs. what is bluster. Harrowing to individuals not used to such changes, especially to those who assume the stock market is always a logical cash flow discounting mechanism. There are times when the stock market does not act rationally. The last few weeks have been one of those times.
The first defense against headline risk is diversification. Broadly diversified portfolios fared better than concentrated or narrowly focused portfolios. Second, recognize irrationality does enter the stock market, yet the irrationality adrenaline hit will ultimately subside with more frontal lobe reasoning. Lastly, it is best not to get too wrapped up in the minute-by-minute news cycle. Just wait, and the headline will change. Clearly, there is a uniqueness to the recent weeks, but markets have seen irrational anxiety before.
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