Bad news with a high degree of ambiguity further exacerbated any reaction by markets. Larry Epstein and Martin Schneider in their February 2008 Journal of Finance paper, “Ambiguity, Information Quality and Asset Pricing” derive some interesting results with investor behavior. When there is a high degree of ambiguity, there will be a stronger more persistent reaction to bad news.
The logic to the reaction is that when there is a high degree of ambiguity, investors cannot determine the distribution of the information signal so they assess the information under the worst case scenario. Good news signals will not be that good and bad news will be thought to be worse. Information which is less familiar will be more ambiguous. Information which is less certain will be heavily discounted.
Ambiguity and low information quality in the current situation explains why there was such a large market sell-off. The terms of the Treasury TARP program, the ballooning of the Fed balance sheet, and the valuation of any holdings by financial firms of poor assets have all been uncertain and ambiguous. The pure information signals were weak and the potential reaction from both investors and the government were also uncertain. Therefore the reaction of a flight to quality is reasonable and will cause strong negative trends in markets. Macroeconomic signals which have been skewed to bad news have further caused investors to assume a worst case scenario and result in a more dramatic market moves.
Ambiguity and low information quality in the current situation explains why there was such a large market sell-off. The terms of the Treasury TARP program, the ballooning of the Fed balance sheet, and the valuation of any holdings by financial firms of poor assets have all been uncertain and ambiguous. The pure information signals were weak and the potential reaction from both investors and the government were also uncertain. Therefore the reaction of a flight to quality is reasonable and will cause strong negative trends in markets. Macroeconomic signals which have been skewed to bad news have further caused investors to assume a worst case scenario and result in a more dramatic market moves.
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