With a Grain of Salt: Uncertain Relevance of External Information and Firm Disclosures

This paper examines how uncertainty about the relevance of external signals (such as news about a competitor or about changes in macroeconomic factors) influences investor beliefs, market prices and voluntary disclosures by companies. Despite assuming independence between the signal relevance and the endowment with information of a firm manager, our results show that: (i) favorable external signals are perceived to be less relevant; (ii) because such signals are taken ``with a grain of salt," the investor beliefs that the manager is endowed with unfavorable information are reinforced. As a consequence, a discontinuity in investor beliefs and non-monotonicity in stock prices may occur, such that more favorable external signals could paradoxically lead to a decrease in market valuation. In line with the growing empirical evidence in this area, our model predicts asymmetric price reactions to favorable and unfavorable news as well as potential price declines following firm disclosures.