Announcements and News

We need to be careful when we talk about the effect of news items on the return. For example, suppose Flyers's business is such that the company prospers when GDP grows at a relatively high rate and suffers when GDP is relatively stagnant. In this case, in deciding what return to expect this year from owning stock in Flyers, shareholders either implicitly or explicitly must think about what GDP is likely to be for the year.

When the government actually announces GDP figures for the year, what will happen to the value of Flyers's stock? Obviously, the answer depends on what figure is released. More to the point, however, the impact depends on how much of that figure is new information.

At the beginning of the year, market participants will have some idea or forecast of what the yearly GDP will be. To the extent that shareholders have predicted GDP, that prediction will already be factored into the expected part of the return on the stock, E(R). On the other hand, if the announced GDP is a surprise, then the effect will be part of U, the unanticipated portion of the return. As an example, suppose shareholders in the market had forecast that the GDP increase this year would be .5 percent. If the actual announcement this year is exactly .5 percent, the same as the forecast, then the shareholders don't really learn anything, and the announcement isn't news. There will be no impact on the stock price as a result. This is like receiving confirmation of something that you suspected all along; it doesn't reveal anything new.

To give a more concrete example, in July 2001, electronics manufacturer Motorola announced that sales had fallen by 19 percent, producing a loss of 35 cents per share. The next day, the company announced that it would cut 4,000 jobs. This seems like bigtime bad news, but the stock price rose by more than 17 percent over the two-day period. Why? Because market participants had expected an even bigger loss.

A common way of saying that an announcement isn't news is to say that the market has already "discounted" the announcement. The use of the word discount here is different from the use of the term in computing present values, but the spirit is the same. When we discount a dollar in the future, we say it is worth less to us because of the time value of money. When we discount an announcement or a news item, we say that it has less of an impact on the market because the market already knew much of it.

Going back to Flyers, suppose the government announces that the actual GDP increase during the year has been 1.5 percent. Now shareholders have learned something, namely, that the increase is one percentage point higher than they had forecast. This difference between the actual result and the forecast, one percentage point in this example, is sometimes called the innovation or the surprise.

This distinction explains why what seems to be bad news can actually be good news (and vice versa). For example, in May of 2001, retailer J.C. Penney announced that same store sales had risen by 1.1 percent, the first increase in this important measure in over two years. Good news, right? Wrong. Its stock slid by 4 percent on the news. Bigger increases had been expected, plus the company predicted tough times ahead.

Ross et al.: Fundamentals I V. Risk and Return I 13. Return, Risk, and the I I © The McGraw-Hill of Corporate Finance, Sixth Security Market Line Companies, 2002

Edition, Alternate Edition

CHAPTER 13 Return, Risk, and the Security Market Line 425

A key idea to keep in mind about news and price changes is that news about the future is what matters. Going back to the Worldcom example we used to open this chapter, Worldcom also announced that prices in the telephone and data services markets appear to be stabilizing after several quarters of declines, which was good news about potential future profits in these key areas.

To summarize, an announcement can be broken into two parts, the anticipated, or expected, part and the surprise, or innovation:

Announcement = Expected part + Surprise [13.4]

The expected part of any announcement is the part of the information that the market uses to form the expectation, E(R), of the return on the stock. The surprise is the news that influences the unanticipated return on the stock, U.

Our discussion of market efficiency in the previous chapter bears on this discussion. We are assuming that relevant information known today is already reflected in the expected return. This is identical to saying that the current price reflects relevant publicly available information. We are thus implicitly assuming that markets are at least reasonably efficient in the semistrong form sense.

Henceforth, when we speak of news, we will mean the surprise part of an announcement and not the portion that the market has expected and therefore already discounted.

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