Does the stock market under-react to the Federal Reserve bank's monetary policy actions?

Review of Business Research, March, 2008 by Levon Goukasian, L. Keith Whitney

In truth, substantial evidence exists to challenge the traditional (semi-strong) EMH that assets are priced to reflect all publicly available information. As noted by Schwert, a number of anomalies have been detected over the past few decades, and new anomalies emerge rather frequently. Again, as Schwert notes, the empirical literature is replete with a variety of studies of corporate news events and disclosures (as noted above, various studies of earnings announcements, stock splits, tender offers, insider transactions, and R& D expenditures) where investors appear to over- or under-react to the news or disclosures. In some cases, the event-date abnormal returns have the same sign as subsequent stock returns for the subsequent (days, weeks, or months) period (Schwert, 2001). Such price movements are indicative of under-reaction. In other words, the studies of these situations have demonstrated that the market reacts slowly in adjusting to the newly available information; hence, prices of the affected stocks lag. Over-reaction occurs when the event-date abnormal returns have the opposite sign of the returns over the subsequent period. On the event-date, the market over-reacts to news and, only later, corrects the over-adjustment.

As indicated, in order to understand the process of price adjustment to newly available information, a rational expectations framework has been employed (Brown and Jennings, 1989, and Grundy and McNichols, 1989). However, actions of market participants that affect prices are dependent on additional factors that explain human behavior, including biased behaviors. Thus, behavioral models have been used to explain anomalies. Human psychology suggests that participants may be prone to actions that can affect stock prices, but that are not particularly rational (Barberis et. al., 1998; Daniel et. al., 1998; Hong and Stein, 1999; and Hirshleifer, 2001).

2. A BRIEF REVIEW OF OTHER RELEVANT STUDIES

We will examine in a little in detail a few studies that are particularly relevant to the study at hand because they examine over- and under-reaction related to securities markets or market indices. First, Ajayi and Mehdian study investor over-reaction to unexpected news or events that affected major international stock markets (Ajayi and Mehdian, 1994). In fact, their objective was to test the hypothesis that the market indices for eight international stock markets over-reacted to newly disclosed and unexpected events (news). The results of their study were mixed in that they found support for over-reaction in some of these markets, under-reaction in others, and market efficiency in still others.

In 1968 researchers Ball and Brown first reported one of the most persistent anomalies, the so-called "post-earnings-announcement drift" (Ball and Brown, 1968). [See also Bernard and Thomas, 1989; Chan, Jegadeesh, and Lakonishok, 1996; and Doyle, Lundholm, and Soliman, 2003 for more recent studies.] While the EMH would suggest that the receipt of new information leads investors to instantaneously adjust their expectations regarding a firm's future earnings and take action (buy or sell) that would likewise be instantaneously reflected in new, but appropriate stock prices. Beginning with Ball and Brown, researchers have been able to consistently find evidence that documents that stock prices continue to drift for a long period after new earnings announcements. In fact, Fama comments on this stream of research by boldly stating that the post-earnings-announcement drift is an anomaly that is above suspicion (Fama, 1998). While we do not deal with earnings announcements, we note that these various research studies have documented well that investors often react slowly in adjusting their expectations regarding the future earnings of the firms in which they have invested. In other words, we take note of this response, often termed a "delayed response hypothesis." We also note that few studies have tested this hypothesis by focusing on the speed at which investors adjust their expectations after news releases or events. Bernard and Thomas (1989) suggest that the "delayed response" hypothesis is a more likely explanation for the drift. Hong and Stein (1999) propose that the market under-reacts because private information diffuses gradually across investors. They suggest that, although the news itself is pubic, some other, private information may be needed in order to convert this news into a judgment related to value. They call this explanation a "gradual information diffusion" explanation. Barberis, Shleifer, and Vishny (1998) propose a model of investor sentiment to explain market under- and over-reaction. Their model is based on literature related to the psychology of decision-making. In particular, they suggest that market under-reaction is consistent with a phenomenon documented in psychology. What psychology refers to as "conservatism" in decision-making is defined as the slow updating of models in the presence of new information.