Lessons Learned From The Stock Market Reaction To The Tax Bill

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The stock market has, it seems, been waiting with bated breath for the tax bill that was signed into law yesterday, so, with a massive cut in the corporate tax rate and some pretty hefty tax relief for individuals now on the books, we are all set for a massive rally, right? Well, no, or at least not on the evidence so far.

What we are seeing instead is a version of the classic “buy the rumor, sell the fact” (or BTRSTF, as I will refer to it) pattern that in this case is more accurately described as “buy the rumor, ignore the fact.” These patterns happen frequently, so it is worth a quick look at why they occur, and how to avoid getting caught when they do.

The S&P 500 hit a high of 2694.97 on Monday, but once the tax cuts passed, we closed yesterday down on the session at 2679.25 and is slightly up in pre-market futures trading this morning. That is not a significant selloff, which is why I said this is about ignoring, rather than selling, the fact. But still, if you bought over the last week or so in expectation of a pop when the bill passed, you would have been sorely disappointed.

If that expected boost from the tax bill was your trade thesis and it didn’t materialize, the chances are that at some point you will be disappointed enough to sell and close out your position. Multiply that response by thousands of traders, and you will begin to see why understanding BTRSTF is so important.

The buying in anticipation of an expected event is usually spread out over a long period of time, whereas the selling tends to be concentrated in the days, sometimes even the hours, immediately following the news. Even if that selling is to take a profit, it distorts the market and can cause quite alarming moves back down, even though the event came as predicted.

At the very least, as we saw yesterday, it limits the upside.

It may seem to some that if you made a profit on the trade, so what? That, however, is to misunderstand what trading is essentially about, the balance between risk and reward. When they entered the trade, buyers, especially the late entrants, did so with expectations of a level of profit that made the risk look worthwhile. Those expectations were, as is now obvious, wrong, but the risk was still there.

The unity we are seeing around the bill now looked a lot less certain just a few days ago, and if the Republican coalition had fractured again who knows how low we would have dropped?

That is the basic problem with BTRSTF, especially for those that join in close to the anticipated event. There is very limited upside potential and huge downside risk, and trading like that is a recipe for disaster.

Ironically, the way to reduce risk on a trade like this is to take a riskier trade in the first place. If you buy months in front of an event like this, there is a greater chance of something going wrong, especially with a President who is not averse to tweeting out an insult about fellow party members here and there.

That risk, however, can be controlled with a tight stop loss that you switch to a trailing stop as the event gets closer. If you don’t get in early though, the key to trading these anticipated happenings is simple: Just say no!

I understand that as a move progresses and you see others making big money, FOMO, the fear of missing out, becomes a factor. Looking at a potential trade with an eye to the risk/reward ratio in the future rather than the past may help.

For the uninitiated, BTRSTF is one of the most confusing things about the market, but it is actually quite logical. Markets look to the future, and as that happens, everybody who wants to trade in anticipation of something does so. Once that thing happens though, it is immediately history, and with no-one left to buy the fact, profit-taking often prompts a selloff.

That doesn’t happen all the time, but it does happen frequently enough that traders and investors should expect it and prepare accordingly. Hopefully, if you’ve got this far, you are now a little better prepared for the next time.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , Investing Ideas , Politics , Stocks , Taxes , US Markets

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Martin Tillier

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