A curious phenomenon has emerged in stock markets in the last month. It seems that the usual relationship between corporate financial announcements and stock prices are being reversed by investors’ assumptions that the government will underwrite risk.
Boeing recently published financial results for their first quarter of 2020. Even though earnings per share were well below expectations, the aerospace company’s stock price nevertheless rose by 5.8% on the day the bad news came out. Last month, the cruise line operator Carnival, likewise, saw a 2.4% bump in share price after announcing dramatically worse-than-expected Q1 performance.
When a firm announcing poor results becomes a likely candidate for a bailout, bad news can often be good news. This appears to be inflating firms’ stock prices, despite (or, illogically, even because of) multiple signals that all is not well. By itself, this would suggest that investors are taking riskier and less responsible bets, because they anticipate that the government will come to their rescue. This would be cause for significant concern.
Perverse Incentives Could Follow
But it’s possible that some perverse short-term incentives are being created for executives with bad news to release due to the inversion of typical equity price movements. And this may also be sabotaging a vital check on corporate malfeasance.
A firm’s stock price can be encouraged to float above its true market value should that company withhold important information, make false claims or outright cook the books. This is because the public is being provided with information that is deceptively positive. Investors who paid inflated prices can receive compensation through litigation, however, when such wrongdoing surfaces.
This is by no means an obscure practice. Hundreds of securities fraud class action claims are filed in the U.S. every year on behalf of shareholders trying to recover losses, with average settlement values in the tens of millions of dollars each. Securities fraud litigation not only encourages companies and individuals to be transparent, but also provides one of the only means by which companies can be held accountable by their shareholders.
Under normal circumstances, courts use the shift in stock prices immediately following the discovery of wrongdoing to assign a number to the size of the harm done in a securities fraud case. Markets price this information into their valuation of the company’s stock as new information emerges – often in real-time, and occasionally even mid-announcement during a rush of trading activity. This means the courts can reach a conclusion regarding how much value had been falsely priced into the stock by looking at the size of the correction in the market following the coming to light of wrongdoing—and, subsequently, they can accurately estimate how much investors have overpaid.
But other market effects and information are built into share price movements as well. A standard methodology for isolating the “idiosyncratic” movement of a single firm’s stock price immediately following a disclosure from the movement of the wider sector and market, has come to be accepted by the U.S. courts using regression analysis.
But this tool for estimating harm no longer works in an upside-down environment where, instead of driving stock prices down, poor performance drives stock prices up. In this bizarre environment, managers may in fact be able to reveal wrongdoing without facing consequences, because investors cannot use the existing framework to reach an estimate of their damages when the revelation of bad news causes the stock price to rise.
Class action cases will struggle to survive defendants’ motions to dismiss, because securities fraud claims bear high pleading standards, and parties need to be able to show a plausible estimate of harm at an early stage.
Worryingly for the existing securities fraud litigation framework, the phenomenon of negative disclosures and positive reactions in the equity market seems to extend beyond a few struggling companies. A few weeks ago, the Bureau of Economic Analysis announced a 4.8% contraction of U.S. GDP for the first quarter of 2020, results that are on par with the worst of the 2008-2009 financial crisis; by the end of the day, the S&P 500 index had risen 2.7%.
Even in the face of a challenged economic outlook, stock prices are rising. Major economic downturn has a way of encouraging long-term accounting fraud to reveal itself, as other commentators have noted. But the unprecedented public cash injections for companies brought on by the crisis may also be undermining one of the only means by which investors can hold companies to account for wrongdoing.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Alberto Thomas is co-founder of Fideres, an economic consulting firm specializing in investigating corporate misconduct, market manipulation and abuses. They work alongside law firms and regulators globally.