- A new Review of Financial Studies paper explores how different sources of information influence movements in US stock prices.
- It finds that publicly available firm-specific information is the largest determinant of price fluctuations, but still only accounts for just over a third of the variation in daily returns.
- Noise (31%), privately available firm-specific information (24%) and market-wide information (8%) explain the rest of the variation.
Stock prices impound information. And in finance, the information is typically split into two: market-wide and firm-specific. The former is information on the whole market, while the latter is public and private information on a firm’s fundamentals. Any other information is known as noise.
Investors must understand how stock prices reflect information because it has implications for risk, returns and efficiency. Yet the return-generating process is hard to disentangle, and it can change over time. And so, a new Review of Financial Studies paperuses a new method to understand what information drives stock market prices. They find:
- Noise drives roughly 31% of the variation in daily returns on stocks listed on the NYSE, AMEX and NASDAQ.
- Firm-specific information drives the most stock price movement, and its role has increased over time despite the rise in algorithmic trading and passive investing.
- Since the mid-1990s, noise has decreasingly driven daily return fluctuations – consistent with increasing market efficiency.
Data and Methodology
The paper’s USP is its methodology. First, it is one of only a few to address the role of noise in stock prices. And second, it is able to disentangle the information contained within prices into more refined categories than past papers. The key is that the authors run a variance decomposition model. This methodology can simply attribute the causes of unexpected changes in stock price behaviour to different information groups.
The authors select four information groups in total. The first is market-wide information. Groups two and three relate to firm-specific information. This information is either revealed through trading on private behaviour (group two) or through public news (group three). The last group is noise, which the authors assume to cause any short-term and unexpected changes in daily returns.
To capture market-wide information, the authors use market returns. For firm-specific private information, they use the product of price, volume, and the sign of the stock’s daily return to reflect order flows. Combined, these are a proxy of trading, and the authors assume this reveals private interpretations of public information. Meanwhile, firm-specific public information is what is left unexplained in groups one or two.
For data, the authors use daily returns, prices, market caps, volumes, and sectors on all common stocks listed on the NYSE, AMEX and NASDAQ between 1960 and 2015. They collect these from the Centre for Research in Security Prices (CRSP).
Interpreting the Use of Information
Distinguishing between market-wide and firm-specific information is important because the latter is vital for efficient resource allocation across firms. The amount of firm-specific information in prices is a key measure of a stock market’s effectiveness in its informational role and determines the ‘real effects’ of financial markets. Combined, market-wide and firm-specific information proxy market efficiency.
The authors also discriminate between public and private firm-specific information. Private information determines the extent to which corporate managers can use stock prices to learn about their own firms’ fundamentals and incorporate this information into corporate investment decisions. The amount of public information in prices indicates the quality of the disclosure environment.
Results: The Role of Information in Daily Returns
Chart 1 shows the variance decomposition. Over the full sample (1960-2015), information accounts for two-thirds of the variance in daily stock returns, while noise accounts for the rest. Broken down further, market-wide information is the smallest component, explaining around 8% of stock return variance. Firm-specific public information explains 37% and private information 24%.
The proportions change over time (Chart 1). For example, since the 1990s, firm-specific information has increasingly driven daily return fluctuations. Up to the early 1960s, it accounted for 50% of the variance, but that figure rose to above 70% in recent years.
The rising importance of firm-specific public information coincides with various US regulations. These include the Sarbanes Oxley Act in 2002 and the Regulation Fair Disclosure in 2000. Both increased the quality and quantity of public disclosures. The rising importance of firm-specific information therefore mainly reflects an improvement in overall market efficiency but is also linked to improvements in liquidity.
Meanwhile, market-wide information has nearly always remained the smallest driver of daily return fluctuations. It tends to spike during crises, perhaps as investors search for exogenous factors as guidance.
Results: The Role of Noise in Daily Returns
Noise accounts for one-third of the variation in daily stock returns. This is substantially lower than intraday returns, where noise is estimated to account for 80% of price variation.
Noise rose through the 1990s, spiking in 1997, and has gradually declined since (Chart 1). The authors believe the high noise in prices in the 1990s is partly due to the collusive behaviour of dealers during that period, which involved effectively widening the tick size by avoiding odd-eighth quotes and thereby increasing bid-ask bounce.
Results: How Firm Characteristics Matter
The authors find that noise’s role in prices declines with stock size (Chart 2, Panel D). For example, in small stocks, noise accounts for 36% of stock return variance – about twice that of big stocks at 17%. The relatively low noise in large stocks is likely linked to greater liquidity, making prices less susceptible to temporary deviations and price pressures.
Meanwhile, market information matters more for the daily stock returns of larger firms than smaller ones (Chart 2, Panel A). On firm-level public information, the recent rise appears down to improvements in the corporate disclosures of small firms (Chart 2, Panel C). Lastly, private firm information has been relatively consistent for all sizes of firms throughout the sample (Chart 2, Panel B).
Lastly, the authors ask, do the drivers of daily return fluctuations differ by sector? Not really – noise accounts for more variation in tech, but this is all. This means that changing industry composition in the market is not driving the time series trends discussed above.
Market efficiency is how well market prices reflect all available information. In this paper, the authors broadly show how US equity markets have become more efficient over time. Conversely, the amount of noise reflected in prices has fallen, especially in smaller firms listed on the NYSE, AMEX and NASDAQ. It also shows the importance of firm-specific information when making investment decisions, so do not just look at what the market is doing!
Sam van de Schootbrugge is a Macro Research Analyst at Macro Hive, currently completing his PhD in international finance. He has a master’s degree in economic research from the University of Cambridge and has worked in research roles for over 3 years in both the public and private sector.