The Future Is Now

As the following game illustrates, stock prices respond very quickly to new information. Pretend you have an asset that is useless to anyone but me. Next week I will be willing to pay $60 for this asset. How much is this asset worth today? Obviously, it’s worth $60, yet many investors seem not to understand this game.

Imagine investors believe that the Federal Reserve Board will cut interest rates next week. For reasons I won’t detail, interest rate cuts help stocks. Does this mean that next week stock prices will rise when interest rates fall? Of course not. Say a stock is worth $58 if interest rates are not cut and $60 if they are. If it is known that interest rates will be cut next week, then the value of the stock will increase to $60 today; the market won’t wait for next week. Next week, when interest rates do change, they will not influence stock prices. Interest rate cuts increase stock prices only when first anticipated.

Just as expected interest rate cuts don’t move the stock market, anticipated corporate developments don’t change stock prices. Consider, for example, when the expiration of a patent will hurt a pharmaceutical company’s stock price. When a drug company discovers some useful new compound, they obtain a patent on it. The patent gives the pharmaceutical company the sole right to sell the discovered drug for some limited period of time. After the patent expires, anyone can make and sell the drug. The pharmaceutical company obviously loses lots of money when a patent expires, because it loses its right to be the exclusive provider of the drug.

If a pharmaceutical company’s patent will expire next week, will its stock price fall next week? No, since everybody knows that the patent will expire next week. It can’t be that this week the stock is trading at $50, but everyone knows that next week the stock will trade at only $40. If this were the case, everyone would sell the stock this week, causing its price to fall immediately. If everyone knows the patent will expire next week, then next week’s expiration will have no effect on the stock price. Recall, it’s the announcement of the rate cut that affects the stock market, not the actual rate cut. Similarly, the expiration will affect the stock market when people first learn that a patent will expire. The time at which a patent will expire is known when the government initially issues the patent, so the expiration of the patent affects the stock price when the patent is first given.

For example, imagine that a pharmaceutical company’s stock sold for $50 yesterday, but today the company unexpectedly discovers a wonder drug. Assume that if the company were given an infinite patent on this drug, then the company’s stock would jump to $60. If, however, the company is granted only a 14-year patent, then the discovery will cause the company’s stock price to jump to only $58. Today the stock will trade for $58 since the effect of the patent’s expiration is factored into the stock price when the patent is first issued, not when the patent actually expires.