Stock price swings and fundamentals: The role of Knightian uncertainty

Abstract

As deviations of stock prices from intrinsic values grow, there is a concurrence of novel events that impart instability and, thus, greater uncertainty, onto investors’ understanding of the process driving market outcomes. This paper proxies for Knightian uncertainty based on the frequency of unscheduled, or novel, corporate events reported in the financial news as relevant for share prices and earnings prospects each day. Empirical findings suggest unscheduled events help explain variation in expected returns, especially at longer horizons. Results show a significant positive relationship between the absolute stock price-gap from intrinsic values (based on constant and time-varying returns) and the frequency of unscheduled events through time. When shocks derail the longer-run relationship, the stock price-gap adjusts. Valuation-based gaps generate similar results, but display nonlinear effects with unscheduled events by producing positive and significant coefficients only for the largest absolute gap values.