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How News and Rumors Effect Stocks

A look at how markets and securities may react to news and rumors.

Fortunes change fast in the stock market - so it's critical for investors to stay abreast of investment news in addition to stock quotes and charts. As we saw in the fall of 2008, financial services stocks were hammered, sometimes on the basis of market news alone.

Even if you're a long-term investor, it's important to check your online investments and review the news headlines periodically. Here's what to look for and how news, rumors and uncertainty can affect the price of stocks.

Market news drives stock prices in financials

There's arguably no better examples of how investment news can impact stock prices than the recent crisis in financial services stocks. Here are a few examples:

On September 11, 2008 Lehman Brothers (LEH) announced it was actively seeking a buyer. Right after the announcement, its shares plummeted 45%. Why? Lehman's announcement made it clear they were having troubles finding a suitor. Having to advertise your willingness to be bought isn't usually considered a bullish signal. True to expectations, on September 15 Lehman filed for bankruptcy, the largest bankruptcy in U.S. history.

In the same week, insurer American International Group (AIG) began admitting that its balance sheets were similarly threatened by the subprime mortgage crisis. Between September 10 and September 16, when the government announced a feverishly constructed rescue plan for the insurer, AIG's stock plunged about 80%.

You can see the rise and fall of hope versus fear in XLF, the Exchange-Traded Fund (ETF) tracking the financial services industry. As the U.S. government made announcement after announcement on its bailout package, the ETF bounced up and down accordingly. When the first bailout package was rejected by Congress in late September, the bad news meant bad news for stock prices in the financial sector, too - the XLF dropped almost half its value as investors waited impatiently for the verdict from Congress. When a revised bailout package finally passed, the market news perked up as well, stabilizing XLF.

"Buy on the rumor, sell on the news"

A curious fact - and one that is key to understanding stock prices - is that good news doesn't always translate to a jump in stock price; in fact, often the good news will produce a slight drop in a stock price. Why? Because unofficial news, also known as "rumors", can have as much impact on stock prices as official news announcements. The stock market often anticipates these news stories and "prices in" its expectations accordingly. When those expectations are confirmed with actual investment news, the price may temporarily drop.

Of course, the reverse applies, too: if rumors swirling around a stock aren't proven true, investors may respond in surprising ways. If the surprise is a good one, stock prices can be driven upward as a result. That's why it's key to watch the investment news online and see how headlines influence stock quotes.

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