The nuances of 'buy the rumor, sell the news'

Pam Moutlon
Moulton
Roni Michaely
Michaely

Traders are often urged to “buy the rumor, sell the news”: Before a big announcement on a stock, trade based on the likely news. Once information has officially been released, reverse the trade, reaping short-term profits.

Recently, a trio of researchers, including Pamela Moulton, associate professor of finance in the School of Hotel Administration, and Roni Michaely, the Rudd Family Professor of Management and professor of finance at the Samuel Curtis Johnson Graduate School of Management and at Cornell Tech, along with Ohad Kadan, a researcher at Washington University in St. Louis, studied the patterns of buying and selling by different categories of traders in the days just before and after analysts issued buy or sell recommendations for specific stocks.

“[The public announcement of analyst recommendations is] a time when important information comes out, and some – but not all – traders may know something about it in advance,” Moulton says. “Who’s benefiting? And who is potentially being harmed?”

Traders with advance information typically “buy the rumor” – but only a portion of them “sell the news.” And those most affected by these short-term trades were more likely to be institutional traders – not individual investors.

The researchers studied these questions thanks to a unique slice of proprietary data from the New York Stock Exchange (NYSE) available to Moulton, a former economist for the exchange. The NYSE data included 11 years of daily buy and sell volumes, along with information classifying buyers and sellers as retail investors, market-makers or institutions.

Institutional trades were subdivided into three categories. The first was program trades: orders for multiple stocks, unmotivated by news of any specific stock. The other categories were proprietary trades, in which NYSE member firms trade for their own account, and agency trades, in which these firms order for their customers; these two trade categories represent news-driven traders most likely to have brief information advantages over other investors.

The team found compelling trends. Four days before an analyst announced an upgrade on an individual stock, proprietary and agency institutional purchases spiked. On the day of the upgrade announcement, only proprietary traders sold a significant portion of their earlier purchases to snare a quick profit. Agency traders appear to hang on to the stocks beyond the day of the announcement, benefiting from the early information but not immediately selling to net a profit.

Moulton, Michaely and Kadan discovered the gains for proprietary traders were significant: The average return from “buying the rumor” a few days before an analyst upgrade and “selling the news” on upgrade day (or doing the reverse for a downgrade) was 1.71 percent. Annualized, the numbers jump to 106.9 percent.

The timing of the pre-announcement trades was consistent with the idea that proprietary and agency traders were being “tipped” about analyst recommendations before they were publicly announced.

Moulton said this “information leakage” is one of multiple possibilities. “It’s possible that at the same time analysts on Wall Street are changing their minds from neutral to buy, for example, a portfolio manager’s own analyst, who is looking at the same public sources of information, might also be making the same judgment,” she says. “But it’s also possible that someone at a Wall Street investment bank might tell their best institutional clients when they’re planning to upgrade a recommendation on a specific stock. Both things are possible, and, at least during our sample period, neither was illegal.”

Either way, proprietary and agency traders benefit from this early information. But who’s on the losing side?

“We find that individuals are not the major seller to [informed traders] before the recommendations are announced,” says Michaely. “Instead, we find that the sellers are those traders who just trade on indices and don’t pay attention to particular stocks.” In fact, these program investors are buying and selling in a nearly mirror image to their informed counterparts.

Moulton suggests the patterns she and her co-authors discovered aren’t necessarily worrisome but may indicate profoundly different investing strategies. Proprietary and agency traders are sensitive to short-term moves and trade accordingly, but program traders who seek to make profits over longer time frames are less likely to be interested in taking advantage of the market’s daily hiccups.

The team’s findings may be relevant to scenarios in which investors have short-term information advantages, such as high-speed traders who pay for news feeds that give them information fractions of a second faster than other traders, for example. “The effects we document around analyst recommendation changes occur over a period of days,” says Moulton. “But one could imagine the same thing happening over shorter time periods of hours, minutes or even seconds.”

To learn more, access the working paper here: Trading in the Presence of Short-Lived Private Information: Evidence from Analyst Recommendation Changes.

This article originally appeared in Cornell Enterprise magazine.

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Melissa Osgood