Financial Regulation, Information Uncertainty, and Stock Returns

Abstract

We examine the joint impact of six financial regulations on the information efficiency of US stock markets. Following the decline of investor confidence in financial information as a result of biased sell-side analyst research in the years leading up to the market peak of 2000 as well as corporate scandals such as Enron and WorldCom, a series of regulations curbing abusive analyst and financial reporting behavior were enacted between 2000 and 2003 to strengthen the information environment of US capital markets. These regulations included Regulation Fair Disclosure, NASD Rule 2711, NYSE Rule 472, the Sarbanes-Oxley Act, the Global Research Analyst Settlement, and Regulation Analyst Certification. Merton (1987) suggests that incomplete information can cause asset pricing predictabilities to arise even if the capital market is dominated by rational agents. Existing literature confirms this assertion using cross-sectional evidence (e.g., Zhang, 2006). We provide time-series evidence by comparing price continuation effects following news before and after the regulations to determine whether their enactment improved the information environment. If the stock price response to news increased as a result of an improved information environment, we expect to find a greater impact among stocks of firms with higher information uncertainty (proxied by size, firm age, analyst coverage, cash flow volatility, and return volatility). We find empirical evidence consistent with this prediction, which is robust to controlling for risk, a time trend, and the recent financial crisis. Unlike existing studies that largely attribute evidence of market inefficiency to investors, i.e. to the demand-side of information, our findings bring the focus back to the supply-side of information, i.e. to financial information intermediaries and providers.