NBER WORKING PAPER SERIES HAVE FINANCIAL MARKETS BECOME MORE INFORMATIVE?

The finance industry has grown, financial markets have become more liquid, information technology has undergone a revolution. But have market prices become more informative? We derive a welfare-based measure of price informativeness: the predicted variation of future cash flows from current market prices. Since 1960, price informativeness has increased at longer horizons (three to five years). The increase is concentrated among firms with greater institutional ownership and share turnover, firms with traded options, and growth firms. Prices have also become a stronger predictor of investment and investment a stronger predictor of cash flows. These results suggest increased revelatory price efficiency. Jennie Bai Georgetown University 3700 O St. N.W. Washington DC, 20057 jb2348@georgetown.edu Thomas Philippon New York University Stern School of Business 44 West 4th Street, Suite 9-190 New York, NY 10012-1126 and NBER tphilipp@stern.nyu. edu Alexi Savov Stern School of Business New York University 44 West Fourth Street, Suite 9-85 New York, NY 10012 and NBER asavov@stern.nyu. edu Fama (1970) writes, “The primary role of the capital market is allocation of ownership of the economy’s capital stock. In general terms, the ideal is a market in which prices provide accurate signals for resource allocation: that is, a market in which firms can make productioninvestment decisions . under the assumption that security prices at any time ‘fully reflect’ all available information. ” Since these words were written, financial markets have been transformed: information processing costs have plummeted, and information availability has vastly expanded. Trading costs have fallen and liquidity has increased by orders of magnitude. Institutional investing has become dominant and spending on price discovery has increased. The financial sector’s share of GDP has doubled. To assess whether these trends have led to progress towards Fama’s ideal, we ask: Have financial market prices become more informative? To answer this question, we first derive a welfare-based measure of price informativeness and then document its evolution over time. Using U.S. stock market data from 1960 to 2014, we find that among comparable firms price informativeness has increased at medium and long horizons (three to five years) while remaining stable at short horizon (one year). Our results from a number of tests support the interpretation that greater information production in financial markets has contributed to an increase in the efficiency of capital allocation. Our first task is to come up with the right measure of informativeness. Standard q-theory (Tobin 1969) implies that investment is proportional to the conditional expectation of future cash flows, making firm value convex in this expectation. Intuitively, investment is an option on information, and firm value embeds the value of this option. It follows that aggregate efficiency is increasing in information (Hayek 1945), which can be quantified by the predicted variance of future cash flows (i.e. the variance of their conditional expectation). We are particularly interested in the information content of prices, which is given by the predicted variance of cash flows using market prices as the predictor. Our price informativeness measure is its square root. We construct time series of price informativeness from yearly cross-sectional regressions of future earnings on current stock market valuation ratios (we also include current earnings and sector controls). We focus on the one-, three-, and five-year forecasting horizons and on NYSE trading volume is up 10 times since 1960. Based on French (2008), spending on price discovery has risen from 0.3% to 1% of GDP since 1980.