Does Greater Firm-specific Return Variation Mean More or Less Informed Stock Pricing?

Roll (1988) observes low R2 statistics for common asset pricing models due to vigorous firms-specific returns variation not associated with public information. He concludes (p. 56) that this implies “either private information or else occasional frenzy unrelated to concrete information.” We show that firms and industries with lower market model R2 statistics exhibit higher association between current returns and future earnings, indicating more information about future earnings in current stock returns. This supports Roll’s first interpretation – higher firms-specific returns variation as a fraction of total variation signals more information-laden stock prices and, therefore, more efficient stock markets