In the first edition of Short n’ Sharpe, I would like to focus on the significance of News Analytics – a study of how news and information impacts the price formation, volatility and liquidity of a security or index (Mitra, OptiRisk, 2011) – in the context of financial markets and “tactical” (i.e. short-term, time-sensitive) portfolio allocations. In the process, we will also observe the crucial role of cognitive biases – apparently one of the principal deficiencies of the Efficient Market Hypothesis (EMH) – in the investment process, which in turn makes quantifying the extent of sentiment/momentum that much more crucial.
One might ask, is there a compelling reason to believe that systematic news analysis could help active market participants effectively capture alpha? Evidence suggests that the answer to that question may well lie in the affirmative; the answer is, in fact, embedded in frequent deviations of market valuations from underlying fundamentals until the news data-points are digested and reflected in asset prices. Put another way, it is through news analysis that we endeavor to disprove, albeit primarily in the near term, one of the EMH’s primary contentions – that “market participants [will] not be able to systematically profit from market inefficiencies” (The Efficient Market Hypothesis, Wikipedia). Let’s consider a recent case where monitoring news-flow consistently and analyzing it methodically might have helped investors beat the market – that of how the politically controversial proposal of Foreign Direct Investment (FDI) in India’s multi-brand retail sector affected the share price performance and tradability of the country’s flagship department store owner, Pantaloon Retail.
I first go back to October 18th, 2011. This is when the Business Standard first reported the possibility of an FDI bill being introduced in Parliament as a standalone measure (Decision on multi-brand retail by year end, Business Standard ), thereby marking the inception of persistent speculation and news-flow around this issue. The proposal would be immensely positive for Pantaloon whose balance sheet held US$1bn in cumulative debt. As expected, trading volumes on Pantaloon’s stock spiked up as did its Implied Volatility, as shown in the charts below:
Pantaloon Retail – Share Price Action + Trading Volumes 2011 (Source: Bloomberg):
Pantaloon Retail – Implied Volatility (Source: Bloomberg):
Interestingly, however, despite the fundamentally positive nature of the proposal for Pantaloon’s balance sheet (and consequently its equity value), the stock collapsed by 19.82%. Why the divergence? This is where cognitive bias comes into play. Investors felt little confidence that the FDI bill, a standalone proposal at the time and a risk to India’s multiple small mom-and-pop shops, would be politically controversial and hence get opposed aggressively by socialist politicians in Parliament, then in session. Needless to say, the crowd was right. The bill was quashed and Pantaloon’s stock fell further post the revocation (FDI in retail – Opposition to corner govt in Parliament, Times of India). The underlying sentiment from a seemingly positive development, well, wasn’t as positive!
The bottom-line? An amalgamation of headline news and market/investor sentiment had impacted Pantaloon’s stock price, volatility and liquidity. As speculation surrounding this issue stayed elevated, so did implied volatility levels as indicated in the chart above.
Let us now fast-forward to September 14th, 2012. This is when the Cabinet finally approved the same measure along with many others. With Parliament not in session and the government’s principal opposing ally no longer a part of its coalition, there was little room for pushback and the bill was ratified into law immediately. Once again, a constructive outcome for Pantaloon, which now holds US$1.2bn of cumulative debt on its balance sheet (US$200mm more than a year ago). The positivity pertaining to the issue, unlike in October 2011, appeared more definitive and potent this time (FDI in multi-brand retail comes into effect, Hindustan Times). As in late 2011, Pantaloon’s trading volumes and volatility levels spiked up again. However, this time, since the announcement, the stock rallied, not collapsed, by 20% (37% to peak post the news) with the benchmark Sensex up 10% during the same period. Investors felt much more confident this time and, had they bought the stock, would have successfully generated alpha.
Pantaloon Retail – Share Price Action + Trading Volumes 2012 (Source: Bloomberg):
The above example explicitly showcases the role of cognitive biases in tactical investing, as well as how collective “sentiment” and its relevant magnitude (i.e. the relative extent of positivity or negativity, measured through linguistic readers and similar software; Thomson Reuters and RavenPack term such metrics “sentiment scores” and “news scores” respectively) have the knack of incorporating more than mere fundamentals in influencing and/or guiding asset prices (in our case, Pantaloon’s equity value).
The necessity of constantly quantifying the extent and direction of such sentiment or momentum, and its consequent impact on return/alpha-generation, is thus set to become an important aspect of portfolio management and allocation. In fact, this subject becomes that much more important when viewed against the backdrop of an exponentially higher share of algorithmic trading and Direct Market Access (DMA) pipes across financial markets globally (the subject of the next edition of Short n’ Sharpe).
For now, it seems safe to assume that [systematic] News Analytics – one among multiple modes of investing – might matter more than one thinks it does. How large a component it really becomes within the realm of portfolio management, though, will only be apparent over time.
 Long funds, hedge funds, principal investors and insurance companies.
 The excess return of an investment relative to its benchmark(s), adjusted for a given level of risk