Under-reaction and Over-reaction to new information (EMH)

[actuaryinmaking]

Hello,

I was wondering if someone could explain why the following are under-reaction to events:

2. Abnormal excess returns for both the parent and subsidiary firms following a de-merger.
3. Abnormal negative returns following mergers.

I would have thought a merger would generate good returns and a de-merger would generate poor returns?

Thanks!

 

[John Potter]

I think you've answered your own question! We observe the opposite to what you "would have thought". The market is not reacting enough to do what you "would have thought".

John

 

[fan-vera]

I think you've answered your own question! We observe the opposite to what you "would have thought". The market is not reacting enough to do what you "would have thought".

John

Still not quite get it. For example, the abnormal negative returns following mergers. The merger should bring good returns but the actual return is negative or the difference between actual and theoretical return is negative, so it's abnormal. Do I understand this part right?
If the understanding is correct, then how should I interpret the following sentence in the notes: 'The market appears to over-estimate the benefits from mergers and the stock price slowly reacts as the optimistic view is proved to be wrong'?
Overestimate the benefit from mergers sounds like an over-reaction?

 

[Mark Mitchell]

Think of under-reactions as occasions where the initial movement following the announcement is quite modest/small, but that the longer term impact is much bigger. So the initial change was an under-reaction compared to where the market ended up.

Also, in this context, 'abnormal' means something like 'unusually large in size'.

So when mergers occur, markets 'over-estimate the benefits' of what essentially turns out to be a negative event from an investment point of view. This might result in an initial positive movement, or possibly, a less negative movement than the true movement. The initial movement isn't that big. Over time, the market realises that the merger was a bad event, and the end result is large negative returns - much more extreme than the original movement, hence the market 'under-reacted' to the news.

Perhaps reading 'over-estimates the benefits from mergers' as 'does not fully appreciate how bad mergers are' makes it easier to see as an under-reaction.