How to Identify and Trade Relief Rallies

By: Wayne Duggan

Chinese e-commerce and cloud services giant Alibaba recently received a $2.8 billion fine from Chinese regulators related to antitrust violations. Coughing up $2.8 billion to the government is not something any company ever wants to do. Alibaba’s financials will certainly take a hit from the fine in the near term, but the company’s stock price had what some traders may see as a counterintuitive reaction to the news.

Alibaba’s Relief Rally
On the first day of trading after the $2.8 billion fine was announced, Alibaba shares gained more than 9%. A stock spiking following news of a nearly $3 billion fine is exactly the type of headline that might lead some inexperienced traders to throw up their hands and proclaim that the stock market is rigged. However, what Alibaba experienced is known as a “relief rally,” and it’s a perfectly reasonable response to a negative headline in certain circumstances.

A relief rally is the market’s way of acknowledging a negative headline that could have been a lot worse. No investor out there thinks Alibaba is a more valuable company without its $2.8 billion in cash. However, it’s important to put the relief rally in context to understand the trading action.

Making Sense of the Rally
Chinese regulators announced the antitrust probe into Alibaba back on December 23, 2020. At the time, Alibaba’s stock price was about $258. Since that announcement, the S&P 500 has rallied about 27%. However, before the relief rally, Alibaba’s shares had traded down to $223.31. Even after the big post-news relief rally, the stock was trading at about $243, well short of its December levels.

Sure, Alibaba stock seemingly reacted positively to bad news. In reality, it overreacted negatively to the news back in December. Alibaba shares are still down about 5.8% overall since the antitrust probe was announced. That drop is where the market is assessing the $2.8 billion in damage.

The main reason the stock rallied following the news is that the market was pricing in the possibility that the fine could be even larger than $2.8 billion.

Identifying Potential Relief Rallies
Regulatory probes, internal accounting reviews and even something as simple as a bad quarter are examples of negative catalysts that can get priced into stocks well before the details become public.

When market expectations for a stock are extremely low and uncertainty is extremely high, the table could be set for a relief rally. A stock doesn’t need good news to trigger a relief rally. Many times, it just needs the bad news to not be a worst-case scenario.

The author is long BABA.

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