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Internet Chat and Market Efficiency

News 1

The Internet helped drive the market value of a little known company called Comparator Systems Corp. from 6 cents to $1.88, then down to 56 cents in just few days before regulators stepped in to halt trading. A trading frenzy on the Nasdaq market was triggered by computer chat rooms, bulletin broads, and discussion groups postings being littered with hundreds of electronic postings on Comparator, a money-losing Newport Beach-based maker of electronic-identification systems.

News 2

On March 29, the WSJ ran a story on how the Internet was used to feed information about Vivus, a drug company. The hyped information first created a boom in the stock, only to be followed by doom.

When Vivus launched its new product in late January, "stock hypers scrambled on-line to investment newsgroups and bulletin boards to spread the word about the tiny company's growth prospects." In two weeks the stock had more than doubled in price to more than $80 from about $37.

As the stock began to peak the online chats began to be negative, combined with heavy short selling. Roughly 3.4 million shares were shorted out of about 16 million outstanding, according to the Journal. On April 31, shares of Vivus tumbled $5.625 to $42.50.

Graphcis

Company Background
On November 25 1996, the company announced Federal Drug Administration (FDA) approval of its new treatment for erection dysfunction. The drug, which is called Muse, short for Medicated Urethral System, treats erectile dysfunction, or the inability to achieve or maintain an erection sufficient for sexual intercourse. It is estimated that some 40 million to 50 million men world-wide suffer from impotence, according to the Journal.

The hype began when a study published in the New England Journal of Medicine on January 3 found that the Muse treatment worked effectively on at least two-thirds of 1,511 impotent men tested.

Analysis

I would like to use these two examples to look at the implications of Internet "chats" on market efficiency.

The best place to start is to consider a popular definition of market efficiency. A market is said to be efficient if all publicly available information is incorporated in stock prices. Using this definition, one can say that the market was efficient in the above scenario, in that it incorporated information coming from Internet "chat."

However, one concern here is the quality of information. Although deceptive advertising is omnipresent, the distinction here is anonymity. People posting electronic messages typically use alias names, making it hard to know the source’s motivation. An investor who likes to see the price of the stock going up would post favorable comments; and negative otherwise. Traditional disclosure of company news or reports, whether good or bad, is typically weighted by investors based on the provider’s reputation. If the provider were known to have come up with good recommendations in the past, investors would be more likely to react positively to the recommendation. Likewise, if the analyst has been wrong often, then investors would tend to discount such recommendations. The bad analysts would be weeded out. Thus, an analyst has an incentive to provide the best analysis that she can. This kind of reputation building is lacking in the Internet "chat" information medium.

Some make the argument that these "chats" are ‘nothing more than a bar where people get together to talk about stocks,’ according to Erik Rydholm, a partner in the Motley Fool, a popular investment bulletin board on America Online (LA Times, June 3, 1996).

‘Someone might say this is the greatest stock since slice bread. But anyone listening should have the intelligence not to take that person at their word,’ adds Mr. Rydholm.

 There are two important differences between bar conversation and the Internet. One difference is that the information on the Internet is reaching, instantaneously, a much wider audience, and thus the greater the likelihood of people reacting to the posting. Another difference is that you have the opportunity to react immediately to the posting using the Internet. All you need to do is check the price of the stock on-line. If the price seems to be going up then you might want to jump in, i.e., the observed stock pattern might give you added confidence in the anonymous announcement. Thus, these two differences might reinforce each other, leading to a snowball effect.

 There is no a priori reason to believe that the postings would favor good or bad news, as investors can make money in either situation. Thus, the impact of such sources would make stocks more volatile, but not necessarily make the market less efficient.

By Alex Tajirian