Surest way to profit from takeover speculation in the stock market is to bet it’s wrong.

Deliberately spreading false rumors may

violate securities laws, especially if

the intent is to sway prices

(appears the SEC quietly endorses rumors if stock

price moves higher, however don't you dare

start a rumor that sends a stock lower...)

By Tara Lachapelle

Jan. 11 (Bloomberg) -- The surest way to profit from takeover speculation in the stock market is to bet it’s wrong.

Electronic news services, brokerages and newspapers reported at least 1,875 rumors about potential buyouts of 717 companies between 2005 and 2010, according to data compiled by Bloomberg. A total of 104, or 14.5 percent, were acquired, the data show. While stocks that were the subject of takeover speculation initially jumped 2.9 percent, betting on declines yielded average profits of 1.2 percent in the next month, an annualized gain of 14 percent.

Opportunities to employ the strategy are increasing as mergers recover from the worst recession in more than 70 years, data compiled by Bloomberg show. After bottoming in 2008, the number of unconfirmed stories about possible mergers surged 71 percent to 611 last year from 2009, data compiled by Bloomberg from more than 50 news providers and brokerages show.

“Sell into the strength,” said John Orrico, who focuses on mergers and acquisitions at New York-based Water Island Capital LLC, which oversees about $2.2 billion. “We see it as an opportunity to sell if we think the rumor is false or ridiculous, which in most cases they are.”

Short selling to speculate on declines on supposed takeover targets produced more than twice the average return generated by U.S. stocks, data compiled by Bloomberg show. At the same time, companies in the Russell 3000 Index had the same chance of being acquired in any 12-month period since 2005 as those that were the subject of merger stories, the data show.

Versus S&P 500

Stocks tracked by Bloomberg fell 0.2 percent, 0.6 percent and 1.2 percent on average in the day, week and month following a rumor report, Bloomberg data show. The S&P 500 rose 0.03 percent, 0.2 percent and 0.5 percent on average during the same periods.

The 14 percent annualized profit from short selling compares with a 6.2 percent yearly return since 1900 before dividends for U.S. stocks, inflation-adjusted data from the London Business School and Credit Suisse Group AG in Zurich show. Short selling is the sale of borrowed stock in the hope of profiting by buying the securities later at a lower price and returning them to the shareholder.

Rumor Origination

“The question that remains unanswered is where does the takeover story originate,” said Michael McCarty, managing partner at Differential Research LLC in Austin, Texas. “It’s most likely from someone who’s interested in selling.”

Deliberately spreading false rumors may violate securities laws, especially if the intent is to sway prices, said James Cox, a professor at Duke University School of Law in Durham, North Carolina. Proving a market-manipulation case is difficult, according to Peter Henning, a law professor at Wayne State University in Detroit and a former federal prosecutor.

“You might be able to see a unicorn before you see a market manipulation case established based on rumors,” Henning said. “It’s so difficult to pin down, and even if you can, to try to link them. You get lots of investigations announced and very few cases brought.”

Manipulation 101

Netlist, Inc. a maker of computer-memory systems, rose 1.9 percent when rumors were reported on Dec. 28, 2009, that Microsoft Corp. might buy the Irvine, California-based company. The shares declined 2.2 percent a day later, 9.4 percent a week later and 31 percent in 30 days.  Complete article by Tara