Do product innovation and news about the R&D process produce large price changes and overreaction? The case of pharmaceutical stock prices

Do extreme price changes of pharmaceutical stocks reflect unexpected scientific information produced during the drug R&D process, especially the approval of new drugs, but also pre- and clinical trial results, recalls and withdrawals? Do stock prices initially overreact to such information? We modelled market-adjusted daily changes in stock prices of the 17 biggest pharmaceutical firms worldwide for the period from 1989 to 2008 to detect large price changes (outliers), using an Autoregressive Moving Average-Generalized Autoregressive Conditional Heteroscedasticity (ARMA-GARCH) dynamic econometric model. Then, we matched those outliers with news produced during the drug R&D process, and tested the hypothesis of no overreaction by examining cumulative abnormal returns. Our results show that there were 261 abnormal market-adjusted daily returns. In 60% of the cases, we were able to assign a plausible cause; i.e. Food and Drug Administration (FDA) approvals in 6% of these cases, news of a scientific nature in another 25%. Only 10 of 1721 FDA approvals of new drugs during the study period were related to abnormally large returns. The impact of negative news items on stock prices is larger than of positive news items. The overreaction hypothesis is rejected; there is no price backlash, therefore, the efficient market hypothesis is not violated.