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What price shocks say about a stock’s future

Volatility and risk

What should investors make of sudden jumps or drops in stock prices that occur for no apparent reason? Rapid and unexplained changes in a stock's price bode ill for the long run.

The phenomenon of a stock suddenly gaining or losing value is hardly unusual. A new study from two Rotman faculty shows that half these price shocks are unaccompanied by earnings surprises or any other news that would account for them.

The research also shows that the effect of these price shocks is likely to be long-lasting. For stocks that experience big unexplained drops, cumulative returns over the following year are about six 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.

"Price shocks can be a warning sign that investors disagree about a company's fundamental value."

- Hai Lu, an associate professor of accounting at Rotman


Those investors 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 accounting, and Kevin Wang, an associate professor of finance, at Rotman.
 
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 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. 

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."

- Hai Lu is an associate professor of accounting, and Kevin Wang is an associate professor of finance, both at Rotman. Read the full news release.

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