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Sudden unexplained jumps or drops in a stock’s price bode ill for the long run says new study from the Rotman School of Management

October 10, 2014

Toron­to, ON — What should investors make of sud­den jumps or drops in stock prices that occur for no appar­ent rea­son? The phe­nom­e­non is hard­ly unusu­al: focus­ing on extreme pos­i­tive and neg­a­tive price shocks, Uni­ver­si­ty of Toron­to account­ing pro­fes­sors find that about half are unac­com­pa­nied by earn­ings sur­pris­es or any oth­er news that would account for them.

The research, in the cur­rent issue of the Amer­i­can Account­ing Asso­ci­a­tion jour­nal, The Account­ing Review, goes on to reveal that the effect of these price shocks is like­ly to be more than tem­po­rary. For stocks that expe­ri­ence big unex­plained drops, cumu­la­tive returns over the fol­low­ing year are about 6 per cent less than those real­ized by shares of a con­trol group of firms. And, para­dox­i­cal­ly, the results for stocks that enjoy big unex­plained jumps are con­sid­er­ably worse — returns about 13 per cent below that of con­trols.

In the words of the new study, “price shocks are fol­lowed by sig­nif­i­cant and long-last­ing abnor­mal returns [that] are asym­met­ric — return con­tin­u­a­tion fol­low­ing extreme neg­a­tive price shocks and return rever­sal fol­low­ing extreme pos­i­tive shocks.”

As for “price shocks with news dis­clo­sures, com­pared to those with­out accom­pa­ny­ing news, [they] are fol­lowed by weak­er down­ward drifts. This evi­dence sug­gests that reduc­tion of infor­ma­tion uncer­tain­ty weak­ens dis­agree­ment-induced over­pric­ing.” Still, even here, the stock returns lag over the course of the fol­low­ing year com­pared to con­trols — by about 4 per cent in the case of neg­a­tive shocks and 7.5 per cent in the case of pos­i­tive shocks.

In sum, “indi­vid­u­als who chase stocks that have recent large price shocks are like­ly to suf­fer sub­stan­tial loss­es,” con­cludes the study by Hai Lu, an asso­ciate pro­fes­sor of finance, and Kevin Wang, an asso­ciate pro­fes­sor of finance, at the Uni­ver­si­ty of Toron­to’s Rot­man School of Man­age­ment and Xiaolu Wang, a doc­tor­al recip­i­ent of that school who is now at Iowa State Uni­ver­si­ty.

The study is par­tic­u­lar­ly sur­pris­ing in two ways. As the authors observe, its focus on price shocks that are unac­com­pa­nied by news events chal­lenges con­ven­tion­al beliefs that “no-news price shocks have no clear infor­ma­tion­al con­tent and rep­re­sent noise to investors. From this per­spec­tive, such shocks have no impli­ca­tions for future returns and are, there­fore, unim­por­tant… [W]e show that no-news price shocks are impor­tant because they are fol­lowed by sig­nif­i­cant and long-last­ing neg­a­tive abnor­mal returns.”

In addi­tion, the paper’s find­ings seem to con­tra­vene pri­or research which sug­gests that long-term price drifts in the after­math of earn­ings sur­pris­es tend to be in the same direc­tion as the sur­pris­es — upward for pos­i­tive sur­pris­es and down­ward for neg­a­tive ones.

What, then, to make of the marked down­ward drift fol­low­ing pos­i­tive price shocks? “Our results sug­gest that sud­den price shocks that occur for no appar­ent rea­son are a sign of dis­agree­ment among investors about an affect­ed com­pa­ny’s fun­da­men­tal val­ue,” com­ments Prof. Lu. “Because of con­straints on short-sell­ing, with the great major­i­ty of mutu­al funds shun­ning it entire­ly, the pes­simism char­ac­ter­is­tic of shorts tends not to be ful­ly expressed in mar­kets. A pos­i­tive shock, then, may be a kind of bub­ble, which, as bub­bles tend to do, deflates in the course of time, turn­ing an unex­plained jump in price into a long-term invest­ment loss.”

The pro­fes­sors gauged short-sell­ing con­straints by the num­ber of mutu­al funds that owned com­pa­ny shares. Since most funds have char­ters that pro­hib­it short-sell­ing, those with neg­a­tive opin­ions of a stock sit on the side­lines, their pes­simistic val­u­a­tions not reg­is­tered in the stock­’s price and their absence in large num­bers beget­ting price infla­tion in the run-up to shocks. Thus, down­ward post-shock drifts are most pro­nounced where fund own­er­ship is low. Returns of stocks in the bot­tom third of mutu­al-fund own­er­ship lagged those of con­trols by 12 per cent one year after pos­i­tive shocks, while those in the top third trailed con­trols by only 4 per cent. The lag dif­fer­ence was equal­ly strik­ing fol­low­ing neg­a­tive price shocks — 6.9 per cent ver­sus approx­i­mate­ly zero.

The paper’s find­ings emerge from an analy­sis of stock price shocks on the NYSE, AMEX, and NASDAQ over the 27-year peri­od 1980 through 2006.

Prof. Lu and col­leagues found, as antic­i­pat­ed, that price shocks were asso­ci­at­ed with upsurges in unex­pect­ed vol­ume of dai­ly trad­ing, which was on aver­age 43 per cent high­er dur­ing the three-day shock than dur­ing the 50-day pre-shock peri­od. Research has equat­ed unex­pect­ed vol­ume (as dis­tinct from vol­ume attrib­ut­able to liq­uid­i­ty fac­tors or to sheer price-change mag­ni­tude) with dis­agree­ment among investors. Over the course of the year fol­low­ing shocks, unex­pect­ed vol­ume reced­ed as investors reached a con­sen­sus on the val­ue of firms. 

Inter­est­ing­ly, con­ver­gence was not prin­ci­pal­ly due to news dis­clo­sures over this time. The pro­fes­sors “do not find evi­dence that the opin­ion diver­gence at price shocks is resolved by sub­se­quent news events,” a find­ing con­sis­tent with ear­li­er research show­ing that “the absence of news reports and the pas­sage of time often con­tain impor­tant infor­ma­tion, and investors incor­po­rate this infor­ma­tion into their val­u­a­tion grad­u­al­ly.”

What accounts for con­ver­gence? While con­ced­ing that the exact cause is still unclear, the authors sur­mise that “one pos­si­ble expla­na­tion is that dili­gent infor­ma­tion search­es by investors lead to grad­ual uncer­tain­ty res­o­lu­tion. Alter­na­tive­ly, ini­tial investor opti­mism may fade when patience runs out in the absence of excit­ing news or a price run-up.”

Enti­tled “Price Shocks, News Dis­clo­sures, and Asym­met­ric Drifts,” the study is in the September/October issue of The Account­ing Review, a peer-review jour­nal pub­lished six times a year by the Amer­i­can Account­ing Asso­ci­a­tion, a world­wide orga­ni­za­tion devot­ed to excel­lence in account­ing edu­ca­tion, research and prac­tice. Oth­er jour­nals pub­lished by the AAA and its spe­cial­ty sec­tions include Account­ing Hori­zons, Issues in Account­ing Edu­ca­tion, Behav­ioral Research in Account­ing, Jour­nal of Man­age­ment Account­ing Research, Audit­ing: A Jour­nal of Prac­tice & The­o­ry, and The Jour­nal of the Amer­i­can Tax­a­tion Asso­ci­a­tion.

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Ken McGuf­fin
Man­ag­er, Media Rela­tions
Rot­man School of Man­age­ment
Uni­ver­si­ty of Toron­to
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