Information Efficiency and Firm-Specific Return Variation

Reasoning that private firm-specific information causes firm-specific return variation that drives down market-model R 2 s, [Morck et al., 2000, The Information Content of Stock Markets: Why do Emerging Markets have Synchronous Stock Price Movements? Journal of Financial Economics, 58, 215–260] begin a large body of research which interprets R 2 as an inverse measure of price informativeness. Low-R 2 s or "synchronicity," as it is called in this literature, signal that prices more efficiently incorporate private firm-specific information, and high R 2 s indicate less. For this to be true, we would expect that low-R 2 stocks have characteristics that facilitate private informed trade, i.e., lower information costs and fewer impediments to arbitrage. However, in this paper we document the opposite: Low-R 2 stocks are small, young, and followed by few analysts, and have high bid-ask spreads, high price impact, greater short-sale constraints and are infrequently traded. In fact, microstructure measures suggest that private-information events are less likely for low-R 2 stocks than high, and that differences in R 2 are driven as much by firm-specific volatility on days without private news as by firm-specific volatility on days with private news. These results call into question prior research using R 2 to measure the information content of stock prices.