At any given point in time, all known information is factored into the financial markets. When new information is released, investors immediately arbitrage any profit opportunities away, thereby "pricing" incoming information into the market. What's more, financial markets are forward-looking in nature – the expectations of each individual investor for market performance are manifested in each company's valuations. In short, perception becomes reality. This is a common study in behavioral finance: trying to understand investor behavior.
These conditions can help explain why a public company's stock can depreciate in value despite reporting record earnings and market share. If expectations of a firm's profitability are not met, it does not matter how successful the company is - its stock valuation will decrease and its market capitalization along with it. According to the Rational Expectations Hypothesis, forecasting errors will be random. This insinuates that the market will on average equal its statistically expected value in the long run.
However, a certain kind of event, known as a "black swan event," does not fit this rule. A black swan event is a seemingly impossible outcome; for example, a Fortune 500 firm discovered falsifying its reported income, or a natural disaster that wipes out a company's competition. When a black swan event occurs, the market comes to realize that its expectations were wildly misplaced and a market correction of massive proportions ensues.
In one of the biggest short squeezes of all time, Volkswagen became "the world's priciest firm" over the course of a single day of trading. At the time, it was believed that Volkswagen was an independent entity in the automotive manufacturing industry. The market held an overwhelmingly bearish outlook on the company's prospects; as a result, the firm was victim to an unusually high amount of short sellers. A short seller is an individual that borrows shares from another party, usually a brokerage, in order to sell the security at its current price and buy it back at a lower one. Obviously, the effectiveness of the strategy is contingent upon the security actually depreciating in value. If the security's price increases, a short seller's exposure to a loss is unlimited.
On Oct. 28, 2008, Porsche announced that it had a 74% ownership share in Volkswagen, taking over its operations. No advance notice was given. Porsche accomplished this in the derivatives market over a prolonged period of time. In the craze that followed, institutions and individuals alike fought tooth and nail to liquidate their short positions as fast as they could. Some sold at prices over 1,000 euros each, briefly making Volkswagen the largest company in the world by market capitalization. The company was up over 93% at its highest point during the one day of trading. Investment funds such as Elliot Associates, Elliot International, The Liverpool Limited Partnership, Perry Partners, Perry Partners International, DE Shaw Valence International and York Capital Management Europe (UK) Advisors quickly moved to press charges against Porsche for intentionally hiding its investment activities from the public eye.
|Volkswagen Stock increase|
Gateway Industries is a success story spawned by a black swan event. Gateway Industries "provides database management services and Website design and maintenance for national not-for profit, healthcare and publishing entities." The company traded for 1 cent a share and was not known to be an extraordinary firm, even within the penny stock market. The company had one employee, its CEO, Jack Howard, and did not seem to be particularly special.
However, on Feb. 11, 2011 it was announced that Robert F.X. Sillerman would be acquiring Gateway Industries. The announcement was completely unexpected. Robert F.X. Sillerman, a world famous media entrepreneur, needed a company such as Gateway Industries in order to fulfill his vision of facilitating interaction between television viewers and shows. The effect was instantaneous: Gateway Industries' stock immediately jumped over 20,000% to $2.97 a share, a move based on Sillerman's reputation alone. Sillerman then consolidated Gateway Industries with a handful of other firms to create his start-up firm, Viggle Inc.
And the Losers
Zynga wildly missed earnings in Q2 of 2012 and fell over 40% in after-hours trading on the same day. Zynga, a technology company that develops online games, works in a close partnership with Facebook. Within the past year, Facebook and Zynga had their initial public offerings. Facebook's IPO was a complete and total disaster; the company's $38 IPO price was criticized by many to be highly inflated, as it equated to a jaw-dropping 107 P/E ratio. Just three months later, Facebook stock dropped down to a low of $17.55. Since then, Wall Street has viewed the tech giants with a healthy dose of skepticism.
Going into Q2 reporting, analysts predicted that Zynga would produce an EPS of 6 cents and revenues of $344.12 million. Zynga traded at $15.91 a share leading into the company's announcement; however, Zynga reported an EPS of 1 cent for the quarter, as well as revenues of $332 million. Even more troubling was the company's revised full-year earnings forecast of 4 cents EPS, given that Wall Street expected an EPS of 27 cents in 2012. As a result, Zynga stock fell down $3.03 in after-hours trading. When a company misses earnings by as much as Zynga did, the market will rapidly correct itself and price in the new information. Once the toast of tech, Zynga is busy playing a game it did not help conceive: survival.
|Zynga Stock Decline|
The Bottom Line
The stock market can be cruel and unforgiving. When weakness in the market is detected, it will react quickly to drive prices down and yields up. This kind of short-term volatility is virtually unpredictable, as it is a result of new information being priced into the market. Black swan events are the most unpredictable of all new information. While we cannot know what form they will assume, we do know that they will occur. Thus, properly diversifying and re-balancing a portfolio can help lower one's exposure to black swan and unsystematic risk.
More From Investopedia