How fundamental events affect stock price

Everyone knows that events are what feeds the market, but how do these events translate into price movement? Any market technician is able to look at the chart of an unspecified company and give a fairly accurate history of the events that shaped its price profile. I know because I’ve wowed my friends with it, and by learning just a few market moving basics, you’ll be on your way to wowing your friends (and yourself), too.

Parlor tricks aside, the main reason you’ll want to learn how to read a chart is to make you money, or at the very least, avoid losing it. In Recipe #5: News Nicoise, we list market moving events and identify ways to profit from them. Some events, however, affect price more than others. Here’s a list of events that generally have the greatest impact: mergers, earnings guidance raised or lowered, credit rating raised or lowered, analyst rating raised or lowered, dividends increased or decreased, stock buy-backs, and sundry corporate events such as accounting irregularities or abrupt changes in high-level management. There are also industry-specific events. For example, the success or failure of a clinical trial has the potential to make or break a fledgling biotech.

Graphic examples of some market-moving events

A bearish example
One doesn’t have to look very far in today’s market to find stinky stock charts. I selected the chart of insurance giant Genworth Financial (GNW) because it illustrates several major events.

A. 11/6 (after market close): Reports huge third quarter loss. Withdraws full-year guidance. Suspends dividend and stock buy-back program. The stock gaps down 14% the next day, dropping another 34% at the close.

B. 11/10 (after market close): Moody’s downgrades the company’s debt rating. Next day, the stock gaps down 25%, closing the day off 40% from the open.

C. 12/8: Proposals aimed at freeing up insurers’ capital are tentatively approved. This cheery news produced industry gains across the board. Genworth gapped up on the open, closing up 42% over the previous day’s close.

This week, the stock has been in an uptrend and has closed the price gap triggered on November 11th. This is a short-term bullish move. Barring any other unforeseen bad news in the financial sector, we could reasonably expect the price to gain another $1.50 where it will have to fill the 11/7 gap at $4. I wouldn’t advise conservative investors to jump in until the stock convincingly clears major resistance at $5.

Note that an “island reversal” was formed between the 11/11 exhaustion gap and the 12/8 breakaway gap. Island reversals don’t necessarily signal a change in direction; they can signal the start of a consolidation process as well which is why I urge all but the speculative to wait until major resistance is toppled.

A biotech example
A couple of years ago, a web acquaintance of mine was touting Northfield Labs (NFLD) as the next biotech giant based on their sole product called Polyheme, a red-blood substitute, that was still in development. So convinced was he of this company’s success that he not only convinced his relatives to heavily invest in it, he also TOOK OUT BIG LOANS (pardon my yelling) to buy more stock! Any reputable financial advisor would have had an apoplectic fit.

Okay, you all know what’s coming here. Take a look at the company’s price movement between the end of 2006 through the middle of 2007.

A. 12/20/06 (before the market opens): Preliminary results of a late-stage trial of PolyHeme show that it failed to meet the study’s primary goals and was shown, in fact, to be inferior to a saline solution. This announcement whacked two/thirds off the stock price in one day.

B. 5/23/07: PolyHeme failed to show any significant efficacy in its Phase III clinical trial. The stock shed over 50% that day. Surprisingly, the company is still around but the stock is now trading around 50 cents, down almost 98% from its $23 high set at the beginning of 2005.

A takeover example
On November 24th (point A in the chart below), Johnson & Johnson (JNJ) announced that it would purchase Omrix Biopharmaceuticals (OMRI) for $25 per share in cash. The stock immediately jumped up 13% on the open and has been trading in a very tight range since. I’m including this chart so you’ll know what a company that is being acquired looks like. Unless there’s some significant short-term money to be made on the transaction (see Recipe #13: Post-Takeover Tacos*), investors should avoid these.

This is just the tip of the iceberg when it comes to technical analysis (TA). My purpose here was to show all of you scaredy-cat fundamentalists that TA is not Jamaican voodoo but more like the map of the mind of the investing collective. It’s really not that tough, and once you’ve analyzed a half a million charts or so, you’ll get the hang of it.

In the next day or so I’ll be showing you how you can use a chart to quickly and accurately determine that slipperiest of fishes: the exit point to a trade.

A useful charting tool
Google Finance provides stock charts with news flags that are described in an adjacent scrolling menu. You can set up this feature as well as adding dividend flags and stock splits to your charts via the settings tab. Nifty, no?

*My MANDA (M & A) Portfolio is based on this recipe and Mario Gabelli’s ABC Fund operates on similar principles.

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