I have said repeatedly over the past couple of months, the stock market is priced for perfection with little room for error. An unexpected event or new information regarding a company can generate huge fluctuations in value. As I’ll explain below, long-time investors need to begin thinking differently about valuing stocks.

Once upon a time (actually, about 30 years ago) a stockbroker would spend most of his or her time perusing financial statements of the companies they followed to build a case for buying its stock. Only after several days of compiling data and analyzing industry trends would a decision be made whether to recommend a stock to clients or continue to watch it until conditions were more favorable.

However, every once in a while, an unexpected development might alter the fundamental thesis for owning a stock, at which time the entire process would be repeated to determine if a change in opinion was in order. But it would take a change of substantial magnitude to justify going through the arduous process of calling every client that owned the stock to explain why it should be removed from their portfolios and obtain their approval to do so.

Those days are long gone. Since the advent of the PC and Internet, most financial advisors rely on an in-house research team or an external advisory service to handle that aspect of the portfolio management process. With so much data available from myriad sources, it’s simply too much work for one person to do on their own while also managing client accounts. Because so much of that data is financial or numerical, it can quickly be aggregated and run through a spreadsheet to identify potential buy and sell candidates.

The inevitable result was a proliferation of algorithmic trading programs that employ a set of mathematical formulas to assign value to a stock. That technique worked well when only a small minority of money was managed this way, but as its popularity rose it eventually eliminated the pricing inefficiencies it was designed to exploit.

Combined with the exploding popularity of index investing, the outcome is a relatively small set of large-cap stocks trading in unison based on algorithms that employ nearly identical formulas. This dynamic has been driving the market higher.

The Upside of Surprises                                                      

For that reason, it’s only when something truly unexpected crops up that one of these stocks will trade in a manner contrary to the overall market. Most often it comes in the form of a quarterly earnings report that is much better (or worse) than expected or contains forward guidance that is revised substantially upward (or downward). Other times it is the sudden departure of a key executive that roils existing shareholders, or the emergence of a possible takeover rumor that excites new investors.

Attempting to capitalize on these types of situations is sometimes referred to as “event-driven investing,” and will be increasingly valuable once the current bull market runs out of steam. The trick, of course, is being able to anticipate such an event, and know how to capitalize on it. That’s why Investing Daily hired Linda McDonough two years ago to run its Profit Catalyst Alert service. Linda spent several years at a hedge fund executing an event-driven trading process.

The beauty of event-driven trading is that you don’t have to be in a stock very long, nor do you have to commit a lot of money to it, to generate huge profits. The stock market’s reaction to these sorts of events is usually swift and severe, and leveraged investments such as options can be used to magnify the change in value of the underlying stock.

For example, last month Linda recommended buying a put option on weapons manufacturer Sturm, Ruger & Company (NYSE: RGR) based on her belief that its second quarter earnings report would be far worse than expected (note: a put option increases in value when the underlying stock drops in price). Two weeks later those same puts had doubled in value as nervous shareholders began unloading the stock before the company confirmed Linda’s hunch on August 2. That’s a 100% gain in less than a month, based on nothing more than just the fear of bad news.

Of course, not every trade works out that neatly, but it illustrates the degree to which the stock market has become sensitive to any news that disrupts the “Goldilocks” environment in which it currently exists. As an investor, you need to pay close attention to any events that may affect the value of your holdings, and be prepared to take immediate action if any of them become subject to an event that could significantly alter their value.