Many instances of mispricing in financial markets have been attributed to investor inattention. For instance, in 1997 the pharmaceutical firm EntreMed released a study in the journal Nature reporting that it had developed a potential cure for cancer. EntreMed’s stock price remained stable, but when the New York Times reported on the Nature study six months later, the stock price soared.
“Information about a firm that is released publicly should almost immediately be reflected in its stock price,” says Professor Lars Lochstoer, whose work focuses on the interaction between asset prices and the real economy. “Standard efficient markets theory says that investors should have taken advantage of the earlier release of the potentially groundbreaking cure.”
But as EntreMed’s experience suggests, some investors may not be very good at distinguishing between true news and old news — or they may simply have limited processing capacity that doesn’t allow them to recognize all the relevant news about their investments in a timely way.
Lochstoer acknowledges that investors have to cull through a large amount of information to stay on top of markets. “It’s one thing if information about individual firms sometimes is not being read into market prices promptly and correctly. But can this also be happening at the aggregate market level? Macroeconomic news give information that is important for aggregate stock and bond valuations. As such, it is least likely to be subject to investor inattention.”
To investigate the question, Lochstoer, working with Thomas Gilbert of the University of Washington, Shimon Kogan of the University of Texas at Austin, and Ataman Ozyildirim of The Conference Board, looked to the Leading Economic Indicator. The Leading Economic Indicator, or LEI, is a summary statistic that compiles data from key macroeconomic activities in the United States, including new orders from manufacturers, building permits for new residential housing, stock prices, and an index of consumer expectations. The Conference Board, which publishes the LEI, makes public precisely how it calculates the number — so any reasonably savvy investor can calculate the LEI as soon as the final constituent statistic is released, which happens a full day prior to each reporting period. Published on a predictable schedule, the LEI is perfect for studying the inattentive investor phenomenon, as the stale information it reflects should not affect prices.
Lochstoer and his co-researchers tracked the S&P 500 index futures prices from when the final constituent statistic was public information (24 hours before the LEI release), until the closing price the day following the LEI release for each monthly release from 1997 to 2010. When the LEI release reflected mostly good economic conditions, the index level on average increased 26 basis points (or 0.26 percent) from after the last constituent release until right before the LEI release. In the 5 minutes immediately after the LEI release, the index level rose on average another 5 basis points (0.05 percent), but then quickly decreased about 35 basis points (0.35 percent) — returning to roughly its level at the beginning of the event window. If the LEI number reflected generally negative economic conditions, the pattern was the opposite, with stock prices initially declining. This pattern indicates that inattentive investors confound the LEI release with true news, unaware that the information in the LEI was already reflected in the stock price at the time of the LEI release.
“Savvy investors at hedge funds and other arbitrageurs understand that a certain percentage of investors are going to misread the LEI release as new information, and can front-run their less savvy counterparts,” Lochstoer says. Front-running happens when these savvier investors look at the final number that comprises the LEI, calculate the LEI, and then buy or sell in the right direction, knowing that the inattentive investor will buy if the LEI is generally good when it is released the next day, or sell if the LEI is generally bad. Until the rest of the market catches on, front-running, then, allows arbitrageurs to make a tidy profit — as much as a 7 percent annual return — off the inattention of their less sophisticated counterparts, all with very little market risk.
Lochstoer and his co-researchers found similar patterns in the Treasury bond market, as well as for individual stocks. Further, the authors show that the price-pattern is more pronounced for stocks that are harder to arbitrage.
But these results are more than just a warning that investors should consider the freshness of information. Lochstoer suggests that news organizations have a responsibility to consider how they release summary statistics like the LEI. “The information should be presented very clearly so that investors know that this is a summary of old news and that the information has probably already been impounded into prices.”
Lars Lochstoer is associate professor of finance and economics at Columbia Business School.