The ‘Seinfeld’ Stock Market

Full of sound and fury, Signifying nothing

_{-MacBeth, Act V}

It is tempting to try to attribute every price movement in a stock, or in the aggregate stock market, as a reaction to breaking news or to new information. This practice shows up in the ubiquitous daily headlines and updates: Market Up Due to Good News X or Market Up In Spite of Bad News Y. Our natural inquisitiveness and need for order require not only an understanding of what is happening, but also why it is happening.  The banal reality, however, is that nearly all of the short-run movement in financial asset prices is random and unrelated to company or economic fundamentals. Most of the time, the stock market is like the TV show Seinfeld, a show about nothing.

The mathematical process used to model stock prices is called a Brownian motion, named after English scientist Robert Brown, who looked through a microscope at pollen particles immersed in water and saw that they were moving in random and unpredictable ways. While it is possible to calculate the probability that a particular pollen particle will be in a certain region after a certain time, unlike with other physical laws of motion, it is impossible to predict its future position and motion with certainty. Similar random shocks to stock prices make it a fool’s errand to explain short-term price changes, as futile as trying to explain why you won the last three hands of poker. Only over longer time horizons, when changes in fundamentals overwhelm random shocks, do price movements becomes informative and illuminating.

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The field of behavioral economics has generated a great deal of evidence that agents under-react to new information

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The Dog that Didn’t Bark

Just as news is not always the reason for stock price moves, sometimes the lack of expected news is newsworthy in its own regard. In the 1892 Sherlock Holmes mystery The Adventure of Silver Blaze, the famous detective notes the “curious incident of the dog in the night-time.” When told that the dog did nothing in the night-time, Holmes replies that this in fact was the curious incident. Several academic papers studied such “dog didn’t bark” scenarios, and found that market prices under-react to newsworthy lack of news, leading to predictable price moves in the future.

One such example comes from corporate insider stock transactions. The literature has mostly come around to the consensus that insider stock purchases are indicative of upcoming good news while stock sales are mostly uninformative. In a 2012 paper entitled The Sound of Silence: What Do We Know When Insiders Do Not Trade?,  the authors ask whether the lack of insider trading is also informative. They show that in the context of insider stock transactions, no news is bad news, as insider inactivity is predictive of future adverse information releases and lower stock returns. When insiders refrain from trading for one year, the average abnormal return over the subsequent twelve-month time horizon is 4.3% lower than the case when insiders sell. The authors hypothesize that the main reason for this finding is litigation risk: insiders who know that bad news is coming worry that they will be sued if they sell their stock right before the bad news is revealed to the public, so they refrain from trading.

Mergers

Another instance where the lack of a particular news announcement delivers (negative) information about the stock price is in the area of mergers. After a merger is announced, there is typically a period of time, averaging around six months, before the transaction is closed. At the merger’s announcement, the stock price of the acquired company typically increases, but not to the price that the acquirer agreed to pay because there is a chance that the deal will fall through. Every day that there is no announcement of deal completion, the probability of the deal’s failure rises and the acquired company’s stock price should theoretically decline. The size of these daily price declines should depend on the ex-ante probability of a positive announcement of completion on that day.

In a 2014 article entitled No News Is News: Do Markets Underreact to Nothing?, published in the Review of Financial Studies, Stefan Giglio and Kelly Shue investigate whether market participants are correctly incorporating the passage of time into the stock prices of firms involved in merger transactions. The probability of an announcement of completion (known as the hazard rate) follows a hump-shaped pattern in event time, peaking at around 25 weeks after the transaction is announced (see top panel of graph below). If investors were rational, stock prices of those firms that didn’t announce success would fall each day just enough so that the average return across both types of firms (ones that announced success on that day and ones that didn’t) would stay constant over event time.

Instead, as the bottom panel of this graph shows, average returns are highest during peak completion time (i.e., weeks 22–32 after the merger announcement), indicating that the market is not adequately penalizing those firms that fail to announce completion in that period, i.e., under-reacting to the lack of positive news. There is a big drop in average returns after week 32, as investors finally wake up to the news that the peak completion period is over and the firm failed to announce, indicating that the prospects for merger success are not good.

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Investor Under-Reaction

Beyond the two examples above, the field of behavioral economics has generated a great deal of evidence that agents under-react to new information, especially when it is less visible or if it is bad news. A great example of this under-reaction is the well-documented anomaly called post-earnings announcement drift (PEAD), in which the stock price reacts immediately to a positive or negative earnings announcement but then continues to drift (on average) in the same direction as the original price move for an additional three months. Limited investor attention is usually proposed as the simplest explanation for this anomaly and other examples of investor under-reaction.

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Conclusion

One of the main advantages of financial markets is that asset prices can act as signals about the fundamental health of the underlying companies and broader economy. However, the challenge for those trying to evaluating these signals is that market participants are often slow to react to news (or lack thereof) and that most short-term price movements are just random noise. The words of the great William Shakespeare apply to the stock market, and the media covering it, most of the time: “full of sound and fury, signifying nothing.”

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