(When and How) Do Markets Learn?

Can ideology influence stock price? Research conducted by Edward Zajac (Kellogg School of Management) and James Westphal (University of Michigan) suggests that sociological influences, such as dominant ideologies regarding what constitutes good corporate practices, can determine how investors view corporate policies — and thus how the market reacts to such policies. Specifically, Zajac and Westphal’s study shows that investor reaction to announcements of stock repurchase plans shifted from negative to positive during the mid-1980s, coinciding with a shift in what they describe as institutional logics, or shared beliefs. In fact, they show how strong shared beliefs can become by providing additional evidence that the generally positive reaction to stock buyback announcements persisted despite growing evidence that a substantial number of firms did not implement the repurchase plans. In light of these findings, Zajac and Westphal suggest that the traditional “market learning” view of investor decision-making should be expanded to include an analysis of these and other sociological influences.

Zajac and Westphal begin by documenting a historical shift in institutional logics about good corporate governance, which they characterize as a shift from “corporate logic” to “agency logic.” Corporate logic, which prevailed until the mid-1980s, assumed that top managers were talented and scarce professionals whose unique knowledge equipped them to take primary responsibility for growing the corporation over the long term. Drawing from their prior research, Zajac and Westphal show that for a number of reasons, this dominant ideology shifted during the mid-1980s to agency logic, which has very different beliefs and assumptions. Agency logic focuses attention on the concept that top managers are self-interested (and disposable) agents whose actions may be incongruent with the interests of shareholders (such as spending on corporate jets or wasteful, diversifying acquisitions), unless given specific incentives that would align managerial and owner interests.

In terms of investor reactions to stock repurchase plans, Zajac and Westphal predicted—and found—that investors would interpret such plans differently under each belief system: Agency logic suggests repurchase plans, by essentially giving excess cash back to shareholders, reduce the incentive for executives to squander those funds, while the corporate logic sees repurchase plans as indicating the firm’s prospects are weak, with no better options for investing its extra cash.

This finding shows that ideology can influence stock price, which is surprising, but their next set of predictions and findings is even more surprising. As agency logic became the more dominant ideology in the mid- to late 1980s, and stock repurchase plans became more common, Zajac and Westphal predicted—and found—that a large percentage of firms who had announced repurchase plans failed to implement them. They also show that many firms during the same time period announced new executive incentive plans, citing the agency-based motivation of aligning managers’ interests with those of shareholders, but note that many of these plans were also never implemented. One might expect (from a traditional market learning perspective) that with such available evidence, investors would quickly lose faith in the espoused value of repurchase and incentive plans, and such announcements would lose their luster. But Zajac and Westphal proposed that agency logic had reached such a dominant ideological position that investor reaction to repurchase plans would remain positive and even improve.

Zajac and Westphal’s extensive data includes 463 firms listed in the 1980 Forbes 500 or Fortune 500 and the quantified investor reaction to 860 repurchase plans announced from 1980 to 1994. The first hypothesis—that investor reactions to stock repurchase plans changed from negative to positive in the mid-1980s—was supported, with the market reactions for the last eight years of the study being significantly above normal (Figure 1). The two other, more startling hypotheses—that market reaction to repurchase plans and executive incentive plans would continue to improve even when firms announced but did not implement repurchase plans and incentive plans—were also supported by the data. Zajac and Westphal write, “It is particularly revealing that we find a growing positive reaction to repurchase plans despite a decreasing rate of implementation of adopted repurchase plans over the same time period.” As more firms adopted but did not implement repurchase plans, the market value of repurchase plans actually increased.

Figure 1: Excess returns from stock repurchase plan adoptions, 1980-94

“One hopeful outcome of this study is to make people more skeptical about what they think they already know,” Zajac says. “Stated differently, people should be more careful consumers of these corporate policies.” He continued by saying that the wholesale adoption of any prevailing business logic can lead investors to assume too much and take too much for granted. Investors should be aware of that vulnerability. Because societal factors can influence investors’ decisions, they should question themselves before making investments. An implication of Zajac and Westphal’s work is that ideology, by providing a particular interpretive lens, can move financial markets.

Zajac and Westphal’s work therefore suggests that traditional market learning theory should be complemented with the study of where and when shared belief structures are likely to affect market perception. Their work on financial markets and corporate practices parallels that of psychologists who study consumer markets and corporate products. Zajac says, “It would be bizarre to think that psychological and sociological factors influence consumer markets but not financial markets.” This new look at collective decision-making in financial markets has implications for public corporations of all sizes as well as for the individual investor.