336 B.E. Eckbo et al.
and book-to-market ratio alone may be insufficient as a control for systematic risk. Such
a match ignores the lower risk caused by the issuer’s investment activity, and may lead
to spurious evidence of “abnormal” post-issue returns.
5.1.3. Pseudo market timing
Schultz (2003)proposed pseudo market timing as another rational market explanation
for the weak long-run stock returns observed after equity issues. The premise for the
pseudo market timing hypothesis is that more firms issue equity as stock prices increase.
It is irrelevant for the hypothesis why this happens, but, any of the rational theories dis-
cussed above could be the reason for increased issue activity as stock prices increases.
Regardless of why the number of issues increases, the long-run performance has noth-
ing to do with manager’s predicting future returns.Schultz (2003)shows that if firms
tend to issue stock after stock price increases (for whatever reason), on average issues
will be followed ex post by underperformance. The reason is simple. Consider IPOs and
suppose expected one-period returns are zero for all periods and all IPOs. Moreover, the
return distribution is a bimodal+10% and−10% in each period. Let there be a single
IPO at time zero. If the return in period one is−10%, there will be no new IPOs at time
one. Alternatively, suppose the return in period one is+10% and that there are four
IPOs in this period. Now, compute the one-period abnormal buy-and-hold return for
these two equally likely sample paths. It is 2% for the “up” sample and−10% for the
“down” sample, with an equally weighted average of−4%.Schultz (2003)refers to this
result as “pseudo market timing” because it may easily be confused by the researcher
with real forecasting ability on the part of issuing firms’ managers.
Several authors have explored to what extent pseudo market timing can explain the
low return observed after IPOs.Dahlquist and de Jong (2004), Viswanathan and Wei
(2004), andAng, Gu, and Hochberg (2005)argue that pseudo market timing only is
a potential explanation for the low post issue return when samples are small. Based
on simulation experiments, all papers conclude that pseudo market timing is highly
unlikely to be the main explanation for the low post issue stock market returns. The
simulation experiments assume a stationary event generating process.Schultz (2004)
show that one cannot reject a null that IPOs follow a nonstationary process and goes on
to argue that, although pseudo market timing is a small sample problem, it is likely to
be important in practice. Note thatSchultz (2003)’s pseudo-timing argument also holds
in principle for other security issuances, and in particular for SEOs where the matched-
firm technique also have produced evidence of long-run underpricing by issuing firms
(discussed below).
5.2. Timing theories with non-rational market pricing
5.2.1. Timing of firm-specific returns
The timing hypothesis (“windows-of-opportunity”) builds on the notion that investors
are overly optimistic about the prospects of issuing firms, and as a consequence prices