Surprise! Surprise! Surprise!

By DAVID MOON, Moon Capital Management, LLC
October 7, 2007

Last week we learned several new pieces of economic news. An industry group reported that a gauge of pending home sales had reached its lowest level ever. Sales in the south declined 21.3% from August 2006 to 2007. The dollar continued its slide against the world's currencies. Economists continue to place the odds of a recession as increasing.

Yet the Dow Jones Industrial Average reached an all-time high within 24 hours of all of this news.

Is bad news good news?

No, news is news only if it's new. No one was surprised that the dollar and home sales continued their declines. The Fed's recent rate cut gives everyone permission to anticipate a recession.

Markets move in reaction to surprises. That's why the top-ranked USC Trojan football team fell from the number spot in the polls after beating Washington 27 to 24 a week ago. Pollsters expected a brutal beating. A mere three-point victory was, in the eyes of the football stock market, a defeat for Southern Cal.

It works the same way on Wall Street.

Sometimes, if you get beaten by less than expected, you can move up in the polls − on Wall Street, that is.

On Monday last week, Citigroup announced that its earnings would fall by about 60% from a year ago, due to 'dislocations in the mortgage-backed securities and credit markets, and deterioration in the consumer-credit market.' In other words, they lost a bunch of money.

The stock increased more than a dollar a share that day.

Swiss bank UBS announced it was laying off 1,500 employees, would slash a third of its investment banking assets and expected to lose more than $680 million this quarter.

Its stock rose 3% on the news.

In each case, investors had expected that the negative reports would be even worse than they were. UBS shares were already down 16% this year. Investors feared a larger quarterly loss.

The Citigroup results were bad enough that some investors hopefully speculated that it might prompt the board to fire CEO Chuck Prince. Seeing the stock react positively to that possibility had to make Mr. Prince feel like he'd been demoted to an Earl.

One useful measure of the market's expectations about a company is its price-to-earnings ratio ' that is, how much does the market value each dollar's worth of the company's earnings? The greater the expectations the overall market has for a company, the more room there is for disappointment. Even a positive result can be a disappointment, if the market was expecting a more positive result.

The corollary is also true. Low P/E ratios suggest low expectations, which are often much easier to exceed. That's a positive surprise. News doesn't have to be great in order for a company to produce a positive surprise.

Does this mean that you should only buy companies mired in negative news? Of course not.

The lesson is that there is a difference between the performance of a company and the performance of its stock price ' especially in the short term. The market reacts to surprises.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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