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3 Reasons News-Based Trading Doesn’t Work

News-based trading gets a lot of attention, and occupies much of the financial media’s time. But it isn’t a sound strategy. Here’s why.

I wanted to start my Wealth Daily column by commenting on a question that’s come up a handful of times in recent days. The topic is news-based trading, and these days, it usually surrounds the infrastructure bill that passed Congress late last week.

The idea sounds simple and logical: Given that Congress has said it’s going to spend a bajillion dollars on such-and-such infrastructure projects, doesn’t it make sense that there will be many companies that benefit from that—and thus, shouldn’t the stocks do well? Frankly, I can’t argue with that logic at all—but what I can say is that few (if any) big winners throughout history were ever launched because of an obvious news item, especially when it comes from Congress.

And the reasons why aren’t that surprising.

3 Reasons to Avoid News-Based Trading

First, when it comes to spending bills, there’s a ton of uncertainties: When will the money be spent? Who gets the contracts? Are there any strings attached to the spending that might dampen profits?

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Second, the world isn’t static—maybe the infrastructure bill does help many firms, but maybe that happens at the same time the economy slows down, which nets out any benefit. (I’m not predicting that, FYI, just using it as an example.)

And third, you have to ask, on the margin, how much any extra business will help firm XYZ—maybe a big outfit sees business increase 5% or 10% for a few quarters, which is nice in the real world, but might not be enough to entice big investors to really build big positions.

That last point is key: I will never, ever claim to have the Bible when it comes to growth investing, but in our numerous studies of big stock market winners, there was almost always something durable and unique with a firm that produced rapid and reliable growth for many years. There’s nothing wrong with rolling the dice on a small position or two and dabble in news-based trading, but usually it’s best to just stick with the stock selection system and look for the best merchandise out there—regardless of what Congress does or doesn’t do.

As for the current market environment, I have two thoughts, one short-term, one intermediate-term.

Short-Term Market Outlook

I’m starting to see a few signs of giddiness and “too good to be true” action, which usually coincides with some sort of hiccup.

For instance, here are the assets in all bullish Rydex funds—it’s gone straight up with the market and is now at multi-month highs. Moreover, my Cabot partner-in-crime Jacob Mintz (chief analyst of Cabot Options Trader and several others options trading advisories) has been pointing out that the VIX volatility index has been rising of late even as the market has, too; historically, that signals smart money is starting to hedge, which often precedes some weakness.

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I wouldn’t be surprised if the weakness we saw starting on Tuesday leads to some sort of short, sharp pullback that shakes the tree. Or maybe we see a bout of rotation out of some hot areas and into others. Either way, the risk of some discomfort seems to be rising.

Intermediate-Term Market Outlook

Bigger picture, though, I’m very optimistic, and there’s one main reason for that: It’s been a long time since I’ve seen so many breakouts from big, multi-month launching pads—and from a variety of industries, too. Shown below is a broad selection of charts that have recently gotten loose and/or gapped up hugely on earnings:

Planet Fitness (PLNT) is not a stock you'd find with news-based trading.

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Ford (F) is not a stock you'd find via news-based trading.

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Listen, in the market, there is never any certainty, so it’s possible this massive wave of earnings gaps and breakouts is some sort of spike top. But I doubt it—that might be the case if all this action was coming after a few months of positive action, but this time around, most stocks and sectors have chopped around for the five to eight months, making the recent moonshots look like blastoffs, not blowoffs.

It’s still important but pick your stocks and buy points carefully, but it’s also important to listen to the evidence—which has grown increasingly bullish.

Do you participate in news-based trading? How often do you pick your stocks based on a major news event?

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A growth stock and market timing expert, Michael Cintolo is Chief Investment Strategist of Cabot Wealth Network and Chief Analyst of Cabot Growth Investor and Cabot Top Ten Trader. Since joining Cabot in 1999, Mike has uncovered exceptional growth stocks and helped to create new tools and rules for buying and selling stocks. Perhaps most notable was his development of the proprietary trend-following market timing system, Cabot Tides, which has helped Cabot place among the top handful of market-timing newsletters numerous times.