NEW LOW OBSERVER

The “Setup”

On October 17, 2016, in after hours trading, Netflix (NFLX) stock increased by as much as +19% on news that the company “…beat analyst expectations…”  More than a dozen analysts raised their price targets on the stock based on the upbeat news.  In one odd case, an analyst who issued a “sell” rating on Netflix also increased the price target, presumably being right about the price increase AND the forthcoming decline (always right, these guys).

Underneath all the excitement, Barron’s cited Citigroup’s Mark May and Kenneth Dorell as saying the results were actually “better than feared” as it was highlighted that:

“Following a disappointing 2Q report (including 3Q guidance below forecasts), Netflix reported 3Q16 results and issued 4Q16 guidance above these lowered expectations. While subscriber net adds remain below year-ago levels and cash burn (including content spend) remains high, revenue growth accelerated to 32% (vs. 28% in 2Q) on subscriber growth of 25% (vs. 27% in 2Q) as the recent price increases benefited growth. We believe the stock’s reaction in the aftermarket may be due to a combination of 1) the set-up and negative sentiment heading into the quarter; and, 2) investors rewarding Netflix’s pricing power, as price increases proved not to have an outsized impact on churn.”

That’s a lot of negatives to reward a company with an increase in the stock price by nearly +20%.

The Problem

There is more to this picture than the apparent good news reported after-hours on October 17, 2016.  Regulators, exchanges, institutions and investors are sitting by idly while the credibility of the markets is slowly eroded.  I know you’re thinking, “who said the markets had any credibility”.  While there is always a question of integrity of the financial markets in general, active participants should question the rhyme and reason for after-hours market activity.  Chief among those questions should be, “is it still considered an orderly market if statically insignificant volume can garner outsized gains?”

For example, in the three months prior to October 17, 2016, average daily trading volume for Netflix was 10,204,329.  In the period from the close in regular trading on October 17, 2016 to the open of regular trading on October 18, 2016, the after hours and pre-market trading volume for Netflix equaled 10,138,767.  Additionally, the change in the stock price was +17.97% from the close on the 17th to the open on the 18th.  Finally, the total trading volume on October 18, 2016, excluding the pre-market trading, was 39,968,284 while the actual price change in Netflix stock during regular hours was +1.85%.

So the question remains, is it considered an orderly market when after-hours trading volume does not exceed average daily volume for the last three months but that same volume affects the price so disproportionately? Are investors negatively affected when trading volume is four times the three month average daily volume but the stock only trades up +1.85%?  The answer to both questions is no and yes, respectively.

Orderly markets cannot exist when stock exchanges open in after-hours to some investors (those playing the news release in after-hours) and is effectively closed to those who attempt to live outside of the gyrations of the market.  What everyone hears is the good news about the stock price going up.  However, what is not acknowledged is that short-sellers and good-til-cancel [GTC] orders to buy at a specific price were punished.

The Consequence 

Institutional short-sellers (and individuals) with large holdings were hit hard by being squeezed out of the market at any available price while individual investors who had an order to buy at a set price, say at or above $106 (a technical confirmation of the rising trend), had their orders executed at the opening price of $116 and above, shaving off nearly 10% that could have been realized if the stock replicated the same moves as what the after-hours generated.  However, this would have been unlikely as trading volume on the 18th would have only moved the price from the October 17, 2016 closing price of $98.77 to $100.59.

Many non-market participants and long-only investors would say, “if short sellers are hurt then that is their fault for playing a risky game.”  This seems reasonable until those same investors are on the receiving end of watching their stock get decimated to the downside in the same after-hour market when an otherwise highly liquid stock “gaps down”-5%, –10% or –20%.  This was the case with Intel (INTC) on after-hour trading which saw the stock drop more than -5%, on the same low volume that afflicted NFLX the previous after-hour session.

Financial markets have come a long way since the Nipper Panic of 1901 when short sellers in Union Pacific Railroad were squeezed out of the stock as the price increased from as low a $160 up to $1,000 and closed at $325 all in a single trading day.  However, when investors, regulators, institutions and exchanges ignore glaring issues such as the impact of after-hour trading, we begin to revert to the market we have attempted to avoid.

A Simple Solution

What is the answer to this problem?  Either companies are required to release news during regular trading hours or after-hour activity should be eliminated.  The best option is keep the after-hour trading and require all market relevant news to be done at the middle of each trading day.  This would promote a more orderly and efficient market without the chaos.

Alternatively, a steep price will be paid (by even those who are not participants) for ignoring a basic issue of market credibility, further undermining an already damaged reputation.