Investors Beware: Breaking News and Stock Prices
When publicly traded companies make extraordinary announcements, investors often disagree on the value implication of the news. Yet following such new market information, the stocks appear to be priced by investors wearing rose-colored glasses.
Take Target Corporation (TGT), for example. In January 2011, Target had a market capitalization of about $32 billion when it paid $1.85 billion to acquire the leases of 220 stores belonging to a struggling Canadian retailer and projected to invest over $1 billion more to revamp the stores. At the time, the news media referred to Target’s expansion as “arguably the boldest project in its 50-year history” and the “first big step at becoming a global retail force.”
Target’s expansion was seen a survival mechanism because of the recession and the retailer’s limited growth opportunities in the U.S. Some stock analysts welcomed the move as a way for Target to broaden its customer base and increase earnings growth. Other market observers worried about the risks associated with the ambitiously quick expansion schedule and the high costs of complying with Canadian regulations. On the day of the announcement, Target’s stock price remained virtually flat.
Ultimately, the pessimists turned out to be correct: the expansion turned out to be a huge money drain for Target. When Target’s new CEO took over in April 2014, he closed all of Target’s Canadian stores within a year, writing down billions in losses. In the four years between the start and the dismantling of the Canadian expansion project, Target has earned its shareholders a dismal annual return just under 5%. That was only 2.5% above inflation and substantially below the 15% annual return on the stock market index earned over that period.
The Stock Price Glass is Half Full
Does a company’s stock price correctly aggregate the opinions of optimistic and pessimistic investors following unusual, value-relevant news? Recent research with my co-authors shows that it does not, and, on average, ends up reflecting the opinion of optimistic investors (“Unusual News Flows and the Cross-Section of Stock Returns,” forthcoming in Management Science).
When the news is positive, such as replacing a failing CEO, both optimists and pessimists would agree that the news is positive, but would disagree on the dollar amount of the resulting corporate value increase. Or, for example, when a company announces a product recall, both optimists and pessimists would agree that the news is damaging for the company’s cash flows and its brand name, but the optimists might believe that the dollar amount of the damage is relatively lower.
The reason sentiment ends up reflecting the opinion of optimistic investors is that if pessimistic investors do not already hold the shares of the company’s stock, they would have to sell the stock short (by borrowing it from investors who have the stock and returning it later, after the share price has declined) in order to express their outlook.
However, in the aftermath of unusual news announcements, stock price volatility typically increases substantially because the announcement is out-of-the-ordinary and creates high uncertainty about how the company’s stock should be priced.
Case in point: the substantial increase in stock price volatility of United Airlines (UAL) following the recent scandal of forcibly removing a passenger off a plane, and the fallout public reaction. Because of this uncertainty, investors start updating their valuations whenever any new information comes out (i.e. such as does Target have as many customers in its Canadian stores as projected, or are the store revenues and costs in line with what Target expected?)
Volatility Short Circuits Short Selling
Importantly, price volatility serves as a barrier to short selling. The reason is that even if short sellers are convinced that the stock price is currently too high and sells the stock short, whenever the stock price goes up instead of down, they are forced to put more money into their margin account to maintain requirements. If short sellers do not have enough funds, they are forced to close the short position at a loss.
Game-changing news is typically followed by an increase in investor disagreement and the stock price volatility. But volatility prevents pessimistic investors from expressing their views by selling the stock short. The stock prices end up being too high relative to the average opinion.
In our study, we show that when news—whether positive or negative—is accompanied by a large volatility shock, the stock earns low future returns.
Our recommendation to investors is to avoid stocks that have recently experienced unusual but value-relevant news events. These stocks are, on average, priced to reflect the optimistic view and will likely underperform in the future.