Feedback Effect of Stock Prices on Fundamental Values: Price Manipulation and Herding with Rational Expectations

Abstract

In this paper, we attribute a resource allocation role to stock prices. When informed investors possess private information important to a firm's investment decision, they need to transmit it to the firm manager. A natural way to achieve this is by trading in a way that allows the manager to infer their information. However, when their trading patterns affect firm investments, there is an incentive to generate the pattern the manager responds to. For instance, if managers respond favorably to a string of price increases, later investors have an incentive to manipulate prices by buying shares (after observing earlier investors buying) even with unfavorable information. In most models of rational expectations, such price manipulation results in trading losses and can be supported only by imposing market incompleteness or restricted participation. However, with a feedback effect, just giving investors positive inventory leads to potential herding as investors can recoup their trading loss through the value increase of their inventory. Also, price manipulation is value increasing since informed investors generate investment-affecting patterns only when the resulting investment is desirable. However, since prices are martingales, herding in trades does not translate into serial correlation of returns and momentum based profits.