Proposition 5.If investors are overconfident, then selective events that
are initiated when the stock is undervalued (overvalued) by the market
will on average be associated with positive (negative) announcement-
date abnormal price changes and will on average be followed by posi-
tive (negative) postannouncement abnormal price changes.In Proposition 4 there was underreaction to news arrival but no drift.
Here, drift results from the combination of underreaction and event selec-
tion based on market mispricing. Thus, the model offers the new empirical
implication that the phenomenon of abnormal postevent drift will be con-
centrated in events that select for market mispricing. Evidence recently
brought to our attention supports this implication. Cornett, Mehran, and
Tehranian (1998) find that “involuntary” issues undertaken by banks to
meet capital requirements are not associated with postevent drift, whereas
“voluntary” bank issues are associated with negative postevent abnormal
performance. Since involuntary issues are likely to be less selective than vol-
untary ones, this evidence is consistent with the model.
If the announcement of an upcoming Initial Public Offering (IPO), like
an Seasoned Equity Offering (SEO) announcement, reflects managers’ “bad
news,” then Proposition 5 implies long-run underperformance following
IPOs as well. Since IPO firms are private prior to the event, we have no
data on the announcement-date reaction to an upcoming IPO. However,
the consistent findings of negative stock price reactions to seasoned equity
issue announcements, and of inferior post-IPO accounting performance
(Jain and Kini 1994, Mikkelson, Partch, and Shah 1997, Teoh, Wong, and
Rao 1998, Loughran and Ritter 1997), suggest that an IPO announcement
is indeed on average bad news.^10 If so, the evidence that IPOs internation-
ally exhibit long-run average underperformance for several years after the
issue (Ritter 1991, and Loughran, Ritter, and Rydqvist 1994) is consistent
with the model.
The event-based return predictability of Proposition 5 is not equivalent
to “underreaction” to corporate events. Underreaction to public signals (as
implied by overconfidence) induces positive autocorrelation of returns at
the event date. However, the event realization (in contrast to the event-date
return) may not predict future abnormal returns unless event size/occur-
rence is correlated with prior market mispricing.
We have interpreted the model in terms of firms buying or selling shares to
profit from mispricing. An alternative interpretation is that a manager with fa-
vorable information (*<0) would like to signalgood news to the market, and
chooses an action (such as a repurchase, dividend, debt for equity swap, or
stock split) to reveal his information. With a continuous signal, such behavior
INVESTOR PSYCHOLOGY 473(^10) The initial positive return relative to issue price, “underpricing,” is notan announcement
reaction to the news that an IPO will occur; this news is released earlier.