other favorable events will tend to occur when market, industry, or firm
market/book or price/earnings ratios are low, and equity issuance and other
adverse selective events when such ratios are high. This is consistent with
evidence that the frequency of IPOs is positively related to the market/book
ratio in the company’s industrial sectors (Pagano, Panetta, and Zingales
1998), and that in many countries the value and number of IPOs is posi-
tively associated with stock market levels (Loughran, Ritter, and Rydqvist
1994, Rees 1996, Ljungqvist 1997).
The analysis also implies that event-date price changes (for a given type
of event) should be positively correlated with postannouncement returns.
This is just underreaction, and follows under the conditions of Proposition
1.^13 Also, in the model, because the preevent price run-up maps one-to-one
with market mispricing, better preevent price performance is associated
with worse postevent performance (either including or excluding the event
date). This follows because cov(P 3 −P 2 , P 1 −P 0 )<0 and cov(P 3 −P 1 , P 1 −
P 0 )<0. Intuitively, mispricing arises from overreaction to private informa-
tion, firms select events based on mispricing, and this causes postevent re-
turns to be related to pre-event returns. However, the latter implication is
not robust to reasonable generalization of the assumptions to allow for the
possibility that public information can arrive at date 0 or 1.
Consider, for example, the case of dividend announcements. Firms that
have been performing well enough to generate a lot of cash are more likely
to boost dividends. Thus, a dividend increase will be associated not only
with market undervaluation at date 2 (unfavorable date 1 privatesignal),
but also with good past performance (favorable date 0 or 1 publicsignal).
In this scenario, while the event-date and postevent mean abnormal returns
are both positive, the sign of the preevent mean return will be ambiguous.
We have verified formally that if the event choice (dividend) increases with
both a past (date 1) public signal and the degree of market undervaluation,
then the event may be associated with a positive average run-up, a positive
average event date return, and a positive average postevent return.^14
More generally, whether prior runup (or other price-related indicators
such the fundamental/price ratios) is a measure of mispricing depends on
whether the event in question is mainly selective for mispricing, or depends
INVESTOR PSYCHOLOGY 475(^13) Proposition 1 is based on a nonselective news event, namely, the arrival of s 2. Even
though s 2 is private information here, the result is the same because s 2 is fully revealed by the
corporate action, so that P 2 is identical in all states to what it would be if s 2 were made public
directly. Thus, cov(P 3 −P 2 , P 2 −P 1 ) is the same in both cases.
(^14) Fama (1998) argues that our approach implies that mean pre-event abnormal returns will
have the same sign as mean postevent abnormal returns, and that the evidence does not sup-
port this implication. As discussed above, event occurrence is likely to depend on past public
information, in which case the model implies that average pre-event runup can have either the
same or the opposite sign as average postevent abnormal returns. See Propositions 4 and 5 for
model implications for event study returns that are robust with respect to pre-event public in-
formation arrival. The evidence generally supports these predictions.