How Does Information Move Financial Markets?
The price of securities is largely driven by information — everything from corporate disclosures and analyst reports to tweets on the latest political or economic events. Edwin (Ted) Neave, professor emeritus at Smith School of Business, is developing a framework that is intended to tease out the interplay between fundamental and short-term information and their combined effects on stock prices. He explains his research in this conversation with Smith Business Insight.
Do Markets Reflect All Information?
One of the mantras early on was that financial markets fully reflect all information. That was the prevailing view when I was leaving graduate school in the late 1960s. In time that came to be modified to markets fully reflecting all public information. What the researchers then failed to anticipate was that their view of the world might hold some of the time but not necessarily all of the time.
Toby Moskowitz and his colleagues at the University of Chicago have recently been doing extensive studies on momentum. They have looked at 60 markets and found evidence of prices continuing to move in the same direction in all of these markets, as well as evidence of bargains in all of these markets. And he asks, how do we explain this if markets more or less fully reflect all available public information right away? Another way of putting it would be, if the markets get out of line, why does it seem to take them so long to get back into line? And will they get back into line? The answer is sometimes yes, with a short delay, and sometimes the delay is a long one. Information keeps evolving from one day to the next. Consequently, before we’re used to what we learned yesterday, we’re learning something new today.
Don't Discard Traditional Financial Market Theories Yet
One of the major issues in my research involves trying to determine when market participants think similarly, when they differ, and the typical nature of differences that do arise. For example, many observers held that traditional financial market theory — financial markets fully reflecting all information — failed to detect the 2007-2008 financial market crash in advance. My research suggests that the early theories weren't wrong, but rather applied only some of the time. The key questions of interest involve determining how the theories need to be broadened to take into account what at first seemed like exceptional circumstances. In other words, appropriate application of different versions of theory can be required under different circumstances and at different times.
Building a Diagnostic Toolkit
I started working on this model partly because of some research out of Yale a few years ago. The Yale researchers looked at a couple of financial innovations and noticed that they affected prices in a certain fashion. When securitization first started to take hold and credit default swaps were invented, the swaps seemed to have a downward effect on the market. But the practice of tranching, which divides securities into slices, seemed to have an upward effect, perhaps because different tranches appealed to different investor enthusiasms.
I was intrigued by this. I thought, it’s nice to know that there are upward and downward effects but I’d like to provide a checklist of what causes each of these movements. The line items on the checklist include things like, Are all investors changing their views of the economy’s cash-generation capabilities or is it just their attitudes that are changing? When prices go up, who’s buying: speculators who like to go the upside or hedgers for the downside? What is the relative size of those types of purchases that we could expect? Is this a speculative market or is this a hedger’s market?
I’m at the conceptual stage right now. I’m working with a colleague to see if we can characterize some of these information flows by looking at accounting data. We don’t expect to solve the world’s problems with this but if we can make a couple of effects clearer than they were before, it would be very rewarding indeed.
People Take Time to Learn
One of the ways behavioural finance plays into this is that people take some time to learn. They're assaulted by new information and may not react completely right away. The Moskowitz work that I cited earlier suggests that these things usually take about a year to work themselves through.
Analysts are trying to understand the behaviour of the market and some of the recent studies show that we’re not fully there yet. People find that momentum and value strategies work, but they don’t have explanations as to why. My attempt at an explanation is to say, Look, it’s mostly because of behavioural finance because people take time to learn.
Now, there are some open questions. Does it just take me a long time to hear what’s on the news? Does it take me a long time to figure out what the news means? Or do I have to wait and see what other people are doing before I can figure out the meaning of a new development? Those are three different possibilities.
— Interview by Alan Morantz