We examine whether the price response to bad and good earnings shocks changes as the relative level of the market changes. The study is based on a complete sample of annual earnings announcements during the period 1988 to 1998. The relative level of the market is based on the difference between the current market P0E and the average market P0E over the prior 12 months. We find that the stock price response to negative earnings surprises increases as the relative level of the market rises. Furthermore, the difference between bad news and good news earnings response coefficients rises with the market. ONE OF THE LONGEST RUNNING empirical debates in finance regards the relative pricing of "value" and "glamour " stocks. Beginning with early work by Basũ 1983! and Stattman~1980!, evidence has accumulated that excess returns on value stocks-that is, the issues of companies for which the ratio of earnings, cash f low, or book value per share is large relative to stock price-are greater than returns on glamour stocks, for which these ratios are small. On one side, Fama and French~1992, 1993, 1995, 1996! argue that the observed differential between the returns on value and glamour stocks represents a risk premium. The alternative view, articulated by Lakonishok, Shleifer, and Vishny~1994!, is that the market fails to efficiently price value and glamour stocks.Extending Lakonishok et al.~1994!, recent work in behavioral finance by, for example, Barberis, Shleifer, and Vishny~BSV, 1998! and Daniel, Hirshleifer, and Subrahmanyam~1998! argues that the value0glamour effect is the result of investor psychology. In particular, the model in BSV allows for investor underreaction~in the intermediate term! to single shocks and investor overreaction~in the longer term! to a series of shocks. This model also implies an asymmetry in the returns to value and glamour stocks following a news shock. Following a string of positive shocks observed in, say, glamour stocks, the investor in this model expects another positive shock, that is, he expects the earnings to trend. If good news is announced, the market re-2507 sponse is relatively small since the positive shock was anticipated. A negative shock, on the other hand, generates a large negative return, since it is more of a surprise.The primary empirical tests of the competing explanations for the value0 glamour differential have been conducted on earnings announcements~La Porta,~1996!, Dechow and Sloan~1997!!. La Porta et al.~1997! and Bernard, Thomas, and Wahlen~1997! find that earnings announcement returns explain almost half of the return differential between value and glamour stocks. More recently, Skinner and Sloan~1999! use a sample of earnings announcements and find that when pre-announcement effects are included, the differential reaction to earnings announcements completely explains the differential returns to value and glamour stocks. In addition, Skinner and Sloan also find evidence consistent with the BSV hypothesis. In particular, they find that the response to news is asym...
