A working paper that is nicely summarised on the Empirical Finance Research Blog shows how markets react to information rapidly, that they are not perfectly efficient, and how those setting the efficient market price are rewarded.
The key finding is that returns are lower after information is disclosed, and higher in periods when information is not disclosed. The main implications of this are:
- The market does react rapidly to information (evidence for semi-strong efficient markets)
- The market is not perfectly efficient, because then there would be no reward for fundamental stock picking, which is the mechanism through which the (efficient) prices are set. This is similar to the way in which arbitrage opportunities are limited by arbitrageurs.
- You can make a profit by short selling shares following disclosures, and buying shares on which there is little new information.
- You probably should not buy immediately after new information is disclosed (e.g. not immediately after the results)
There is an alternative, behavioural, explanation for the the first of these: that the market consistently under-reacts to bad news and over-reacts to good news. Given that it is obvious that there must be a market mechanism to reward those who invest based on fundamental research, in order for prices to adjust, the behavioural explanation seems redundant: by Occam’s razor I would reject it pending further evidence.
The main finding is that it confirms a theoretical prediction based on efficient markets. To quote from the blog post:
In the end, one of the basic predictions of the Grossman and Stiglitz theory is that when information is cheap, accessible, and easy to understand, prices will be very close to 100% efficient. Whereas, when information is expensive, has restricted access, and is complicated and time consuming to decipher, prices will likely stray from their “fundamental value.”
The nice thing about this is that it gives us semi-strong efficient markets and a mechanism that compensates those who generate fundamental research.