At any given point in time, all known information is factored into the financial markets. When new information is released, investors immediately arbitrage any profit opportunities away, thereby pricing incoming information into the market. What’s more, financial markets are forward-looking in nature – the expectations of each individual investor for market performance are manifested in each company’s valuations. In short, perception becomes reality. This is a common study in behavioral finance: trying to understand investor behavior.

These conditions can help explain why a public company’s stock can depreciate in value despite reporting record earnings and market share. If expectations of a firm’s profitability are not met, it does not matter how successful the company is — its stock valuation will decrease and its market capitalization along with it. According to the Rational Expectations Hypothesis, forecasting errors will be random. This insinuates that the market will on average equal its statistically expected value in the long run.

However, a certain kind of event, known as a black swan event, does not fit this rule. A black swan event is a seemingly impossible outcome; for example, a Fortune 500 firm discovered falsifying its reported income, or a natural disaster that wipes out a company’s competition. When a black swan event occurs, the market comes to realize that its expectations were wildly misplaced and a market correction of massive proportions ensues.

The Winners

In one of the biggest short squeezes of all time, Volkswagen became the world’s priciest firm over the course of a single day of trading. At the time, it was believed that Volkswagen was an independent entity in the automotive manufacturing industry. The market held an overwhelmingly bearish outlook on the company’s prospects; as a result, the firm was victim to an unusually high amount of short sellers. A short seller is an individual that borrows shares from another party, usually a brokerage, in order to sell the security at its current price and buy it back at a lower one. Obviously, the effectiveness of the strategy is contingent upon the security actually depreciating in value. If the security’s price increases, a short seller’s exposure to a loss is unlimited.

On Oct. 28, 2008, Porsche announced that it had a 74% ownership share in Volkswagen, taking over its operations. No advance notice was given. Porsche accomplished this in the derivatives market over a prolonged period of time. In the craze that followed, institutions and individuals alike fought tooth and nail to liquidate their short positions as fast as they could. Some sold at prices over 1,000 euros each, briefly making Volkswagen the largest company in the world by market capitalization. The company was up over 93% at its highest point during the one day of trading. Investment funds such as Elliot Associates, Elliot International, The Liverpool Limited Partnership, Perry Partners, Perry Partners International, DE Shaw Valence International and York Capital Management Europe (UK) Advisors quickly moved to press charges against Porsche for intentionally hiding its investment activities from the public eye.