When a stock's price drops on heavy volume -- meaning that investors sold the stock in large quantities, usually in a single day -- this is always a strongly negative indicator. But there are different reasons for the sell-off; some reasons are worse than others.
Stocks drop suddenly on heavy volume for many reasons: among them, disappointing financial results, unanticipated product failure and news of severe mismanagement. Sometimes, external events beyond a company's control cause the drop, as happened to airline stocks immediately following 9/11. The common denominator in these sell-offs on heavy volume is investor sentiment. In some instances, the drop may be unjustified economically, and has more to do with investor disappointment following unrealistic expectations. In other instances, the events precipitating the drop foretell a major decline in company fortunes, and disappointed investors are probably right to sell. In both cases, however, behavioral economists increasingly conclude that investor sentiment, more than changes in fundamental values, determines stock market swings.
Really Bad News
Sometimes a company's fortunes change dramatically for the worse. In the early 2000s, Elan, an innovative Irish biotech company, invested heavily in a cure for Alzheimer's. The preliminary results seemed promising. Over a few years, the stock price rose ten-fold. On July 28, 2008, the results of the first clinical trial were released: the drug didn't work and could be dangerous. Elan's stock plunged sharply in a single day. In the five years following, it never sold for more than a third of its all-time high.
Good, Not Great
Sometimes a stock drops on heavy volume when the company's profits are good. On September 17, 2012, Apple stock reached an all-time high of $705 per share. On December 5th, the stock dropped sharply on heavy volume. By the following spring it had dropped further to $385. By then, the company's price to earnings (P/E) ratio was only slightly above $10 per share, unusually low for a successful high-technology company with a history of outstanding growth and admired products. Most analysts believe the company will continue to be profitable, and that the dropping share prices had less to do with decreasing profit margins or declining growth -- the purported reasons for the drop -- than with investor sentiment. Apple investors had become so used to outstanding results, they sold shares in disappointment when they feared future results may be less than outstanding.
Reversion to the Mean
On April 4, 2013, shares of Tesla, an electric automobile maker, fell sharply on heavy volume. The problem began a week earlier when the firm's CEO tweeted news of a soon-to-be-formally-announced financing option. Investors reacted enthusiastically. When the plan was later detailed, while analysts predicted it would lead to increased sales, investors were disappointed nonetheless, and the shares sold off sharply on heavy volume. While investor disappointment factored into the drop, in the previous 3 months the company's shares had risen 20 percent. This kind of explosive growth eventually becomes unsustainable. Without any definitively bad news, and despite increasing sales, Tesla shares reverted to a growth pattern closer to the mean.
- Forbes: Elan Tanks As Buzz For New Alzheimer's Drug Dies
- The Week: Apple's Stock Price Reaches New Low: Why Are Investors So Jittery?
- Two Charts Show Why Apple's Stock Price is Collapsing
- Manufacturing: Disappointed Investors Sell Off Tesla Shares
- Investor Sentiment and the Cross-section of Stock Returns; Malcolm Baker and Jeffrey Wurgler
Patrick Gleeson received a doctorate in 18th century English literature at the University of Washington. He served as a professor of English at the University of Victoria and was head of freshman English at San Francisco State University. Gleeson is the director of technical publications for McClarie Group and manages an investment fund. He is a Registered Investment Advisor.