Do Fundamentals or Emotions Drive the Stock Market?

Emotions can drive market behavior in a few short-lived situations. But fundamentals still rule.

Similarly, irrational investors don’t necessarily drive short-term momentum in share price returns. Profits from these patterns are relatively limited after transaction costs have been deducted. Thus, small momentum biases could exist even if all investors were rational.

Furthermore, behavioral finance still cannot explain why investors overreact under some conditions (such as IPOs) and underreact in others (such as earnings announcements). Since there is no systematic way to predict how markets will respond, some have concluded that this is a further indication of their accuracy. (Eugene F. Fama, “Market Efficiency, Long-term Returns, and Behavioral Finance,” Journal of Financial Economics, 1998, Volume 49, Number 3, pp. 283–306.)

Persistent Mispricing in Carve-outs and Dual-listed Companies

Two well-documented types of market deviation — the mispricing of carve-outs and of dual-listed companies — are used to support behavioral-finance theory. The classic example is the pricing of 3Com and Palm after the latter’s carve-out in March 2000.

In anticipation of a full spin-off within nine months, 3Com floated 5 percent of its Palm subsidiary. Almost immediately, Palm’s market capitalization was higher than the entire market value of 3Com, implying that 3Com’s other businesses had a negative value. Given the size and profitability of the rest of 3Com’s businesses, this result would clearly indicate mispricing. Why did rational investors fail to exploit the anomaly by going short on Palm’s shares and long on 3Com’s? The reason was that the number of available Palm shares was extremely small after the carve-out: 3Com still held 95 percent of them. As a result, it was extremely difficult to establish a short position, which would have required borrowing shares from a Palm shareholder.

During the months following the carve-out, the mispricing gradually became less pronounced as the supply of shares through short sales increased steadily. Yet while many investors and analysts knew about the price difference, it persisted for two months — until the Internal Revenue Service formally approved the carve-out’s tax-free status in early May 2002. At that point, a significant part of the uncertainty around the spin-off was removed and the price discrepancy disappeared. This correction suggests that at least part of the mispricing was caused by the risk that the spin-off wouldn’t occur.

Additional cases of mispricing between parent companies and their carved-out subsidiaries are well documented. (Owen A. Lamont and Richard H. Thaler, “Can the Market Add and Subtract? Mispricing in Tech Stock Carve-outs,” Journal of Political Economy, 2003, Volume 111, Number 2, pp. 227–68; and Mark L. Mitchell, Todd C. Pulvino, and Erik Stafford, “Limited Arbitrage in Equity Markets,” Journal of Finance, 2002, Volume 57, Number 2, pp. 551–84.) In general, these cases involve difficulties setting up short positions to exploit the price differences, which persist until the spin-off takes place or is abandoned. In all cases, the mispricing was corrected within several months.

A second classic example of investors deviating from fundamentals is the price disparity between the shares of the same company traded on two different exchanges. Consider the case of Royal Dutch Petroleum and “Shell” Transport and Trading, which are traded on the Amsterdam and London stock markets, respectively. Since these twin shares are entitled to a fixed 60-40 portion of the dividends of Royal Dutch/Shell, you would expect their share prices to remain in this fixed ratio.


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