The Limitations of Stock Market Efficiency: Price Informativeness and CEO Turnover

Stock prices are more informative when the information has less social value. Speculators with limited resources making costly (private) information production decisions must decide to produce information about some firms and not others. We show that producing and trading on private information is most profitable in the stocks of firms with poor corporate governance – precisely because it will not be acted upon -and less profitable at firms with better corporate governance. To the extent that the information in the stock price is used for disciplining the CEO by the board of directors, the informed trader has a reduced incentive to produce the information in the first place. We test our model using the probability of informed trading (PIN) and the probability of forced CEO turnover in a simultaneous-equation system. The empirical results support the model predictions. Stock prices are efficient, but there is a limit to the disciplining role they can fulfill. We apply the model to evaluate the effects of the Sarbanes-Oxley Act of 2002. * We appreciate comments and suggestions from Alex Edmans, Itay Goldstein, and seminar participants at Georgia State University, University of Miami, and University of North Carolina at Charlotte. We thank Stephen Brown for sharing his quarterly PIN estimates, developed by Brown, Hillegeist, and Lo (2004), and Dirk Jenter for sharing the CEO turnover data, developed by Jenter and Kanaan (2008). We also thank Bunyamin Onal for research assistance. § School of Management, Yale University, New Haven, CT 06520-8200. E-mail: [email protected]. §§ J. Mack Robinson College of Business, Georgia State University, Atlanta, GA 30303. Phone: (404) 413-7346. E-mail: [email protected]. §§§ School of Business, University of Miami, Coral Gables, FL 33124-6552. Phone : (305) 284-8286. Email: [email protected]. Gary B. Gorton Yale University and NBER Lixin Huang Georgia State University