My last over-the-top post reminded me of something that I think many investors feel: the market tends to over-reward stocks on good news and over-punish them on bad news.  The bubble of the late 90s is a good example of over-rewarding.  As for over-punishment, just look at Merck's Vioxx debacle in late 2004 and NVidia's sharp fall in late 2002.

 

Why does this happen?  There's the classic "fear & greed" answer.  I think this is trite, but probably because it's at least partially true:  When playing with big stakes, its easy to become irrational and overswing in the direction of least resistence.

 

I also think there's another reason for at least the over-punishing case: existing versus new shareholder timing.  When severe unexpected negative events (like a major lawsuit out of no where, a massive executive exit, or a landslide in sales) occur for a company, existing shareholders have a pressing need to sell.  Buyers on the other hand have no such pressing need.  This market disequilibrium is hard to avoid and exacerbated by the fact that existing shareholders are more attuned to events about their holdings and are the first to react to and sell on the events.  Other shareholders who may be interested in the stock at its decreased valuation take longer to hear the news, prolonging the downfall.

 

You may observe that hedge funds and the advent of fast and massive mechanical trading should correct this behavior.  However, mechanical trading usually depends on well established patterns or arbitrages and may not react well to severe unexpected events.

 

To capitalize on this pattern, wait for solid companies to release downside surprises to buy shares at a bargain (this probably doesn't work so well for companies that are bad to begin with).  As usual, remember that advice is free for a reason so do your own due diligence :)