What is a 'Catalyst'
A catalyst in equity markets is a revelation or event that propels the price of a security dramatically up or down. A catalyst can be almost anything: an earnings report, an analyst revision, a new product announcement, a piece of legislation, a lawsuit, an outbreak of war or unrest, an offer to buy a company or merge, a move by an activist investor, a comment from a CEO or government official, or the conspicuous absence of a company officer at a special event. In general, it is a news item that has no immediate effect on the fundamentals of a stock, but rattles investors, breaking the price's upward or downward momentum – or sideways lack-of-momentum – and unlocking value (in the case of a rise in price) or bursting a bubble (in the case of a fall).
BREAKING DOWN 'Catalyst'
Depending on their approach, investors will assign different levels of importance to catalysts. Pure value investors ignore catalysts entirely and look instead for operational efficiency, goal-oriented management, reasonable valuation and strong market position. For these investors, catalysts are pleasant surprises – assuming they were correct in their assessment of a company – either providing an opportunity to build up a position cheaply (in the case of falling prices), or realizing the value they'd seen all along (in the case of rising prices). Pure momentum investors, meanwhile, will watch carefully for catalysts, or their effects on prices, trying to be the first to recognize them for what they are and to buy into a bullish turns, or bow out of bearish ones.
In reality, few investors are entirely one or the other, but fall somewhere along the value-momentum spectrum. An investor might concentrate primarily on a company's fundamentals, but acknowledge that a catalyst will be necessary to realize that value. They might devote significant thought to what that catalyst might be, keeping their ear to the ground when it comes to new products and the state of markets where the company operates. At the same time, the bulk of momentum investors will have some sense of what companies might be undervalued or off the mainstream market's radar. They will compile a watch list and a develop a sense of what news might spark price movements, as opposed to being failed catalysts. Few investors focus exclusively on financial statements, at the one end, or retracement levels and trendlines, at the other.
Example of a Catalyst: Nike
Since a catalyst can take any number of forms, it's better to give a concrete example. On August 25, 2015, the S&P 500 Index hit a low for the calendar year of 1867.61, 12.51% below its all-time intraday high of 2134.72, which it had hit on May 20 of that year. The decline, which had begun the previous week and hit its stride on August 24, was the steepest since 2011, and dragged a number of quality stocks down out of sheer panic. Nike Inc. (NKE) was one of these: having closed at $114.98 on August 17, it touched $94.50 on August 24.
Yet the business was as solid as ever, and had very nearly recovered by market close on September 24, reaching $114.79. Later that day, the company reported quarterly earnings that exceeded expectations by 12.61%, and the stock shot up to an intraday high of $125.00 the next day. In other words, the catalyst of an earnings surprise propelled Nike's share price upwards by 9.71% in less than 24 hours (and 33.27% in a little over a month), despite lousy prevailing market conditions.
The change was due to new information and a resulting change in investors' perception, not the fact that Nike was 109.71% as valuable on Friday as it had been on Thursday, or 133.27% as valuable as it had been a month ago. Catalysts arise because of market inefficiencies: herd mentality, information asymmetry, blind spots and out-of-whack valuations.