Wednesday, February 19, 2014

18/2/2014: Have Financial Markets Become More Informative since the 1960s?


In strongly efficient markets, prices of shares transmit strong information about company fundamentals, such as productivity and demand for and risk of investment. As Fama (1970) wrote: "The primary role of the capital market is allocation of ownership of the economy's capital stock. In general terms, the ideal is a market in which prices provide accurate signals for resource allocation: that is, a market in which firms can make production/investment decisions... under the assumption that security prices at any time `fully reflect' all available information."

In recent years, quality of information in the financial markets has significantly improved, while analysis costs have fallen, suggesting that informational content of prices in the markets should have risen as well.

A new paper, titled "HAVE FINANCIAL MARKETS BECOME MORE INFORMATIVE?" by Jennie Bai, Thomas Philippon, and Alexi Savov (Working Paper 19728: http://www.nber.org/papers/w19728, December 2013) measures "the information content of prices by using them to predict earnings and investment. We trace the evolution of price informativeness in the U.S. over the last five decades."

The period of analysis is not ad hoc. "During this period, a revolution in computing has transformed finance: Lower trading costs have led to a flood of liquidity. Modern information technology delivers a vast array of data instantly and at negligible cost. Concurrent with these trends, the finance industry has grown, its share of GDP more than doubling."

In this context, the authors ask "Have market prices become more informative?"

To answer this question, the authors first develop measures of informativeness in the financial markets. They do so by combining Tobin's (1969) q-theory of investment with the noisy rational expectations framework of Grossman and Stiglitz (1980). "When more information is produced, prices become stronger predictors of earnings. We define price informativeness to be the standard deviation of the predictable component of earnings and we show that it is directly related to welfare, as in Hayek (1945): information promotes the efficient allocation of investment, which leads to economic growth."

For empirical testing, the authors regress "future earnings on current valuation ratios, controlling for current earnings. We look at both equity and corporate bond markets. We include one-digit industry-year fixed effects to absorb time-varying cross-sectional differences in the cost of capital. This regression compares firms in the same sector and asks whether firms with higher market valuations tend to produce higher earnings in the future than firms with lower valuations."

Conclusion: "...the amount of informativeness has not changed since 1960."

Surprising result means there is some room for potential mis-specification of the tests. As authors note: "By itself, constant price informativeness does not imply constant information production in markets. It is possible that information production has simply migrated from inside firms to markets. Hirshleifer (1971) first noted the dual role of prices in revealing new information and reflecting existing information. Bond, Edmans, and Goldstein (2012) call the revelatory component of price informativeness real price efficiency (RPE), and the forecasting component forecasting price efficiency (FPE). The financial sector adds value only to the extent that it reveals information that would otherwise be unavailable to decision makers. …the distinction between RPE and FPE is fundamental, and we seek to disentangle them."

The model provides a solution. "When managers rely on prices, they import the price noise into their investment policies. When markets reveal no new information, managers ignore them and prices remain noisy but investment does not. In the opposite case, when all information is produced in markets, managers use prices and both investment and prices are equally noisy. Information increases the predictive power of both prices and investment, but a rise in the revelatory component of prices increases price informativeness disproportionately."

Complicated thinking? You bet. But still, intuitive and testable. "To see if the constant price informativeness could mask a substitution from forecasting (FPE) to revealing (RPE) information, we check to see if the predictable component of earnings based on investment has changed."

Conclusion: the authors find that the predictable component of earnings based on investment has not changed over time. "…this implies that neither FPE nor RPE has risen over the last five decades." And furthermore, "…results show that discount rate variation has also remained stable" over time.

But there is more to the study. It turns out that informativeness is different for different types of investment. "Our strongest positive finding is that a higher equity valuation is more closely associated with R&D investment now than in the past. The same is not true of capital expenditure. However, the increased predictability of R&D is not related to increased predictability of earnings, so we cannot conclude that informativeness has increased."

And the results discussed above are sensitive to the sample of stocks studied. "For most of the paper, we examine S&P 500 stocks whose characteristics have remained stable. In contrast, running the same tests on the universe of stocks appears to show a decline in informativeness. We argue, however, that this decline is consistent with changing firm characteristics: the typical firm today is more difficult to value."

Top conclusion therefore is that having examined "the extent to which stock and bond prices predict earnings", the authors find that "the informativeness of financial market prices has not increased in the past fifty years". 

In the words of Herbert Simon (1971), "An information processing subsystem (a computer) will reduce the net demand on attention of the rest of the organization only if it absorbs more information, previously received by others, than it produces -- if it listens and thinks more than it speaks."
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