When Is Bad News Really Bad News?

Abstract

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...

Testing for asymmetries in price reactions to quarterly earnings announcements on Tallinn, Riga and Vilnius Stock Exchanges during 2000–2009

“…Conrad et al (2002) find that the stock price response to negative earnings surprises increases as the market level rises and the stock price response to positive earnings surprises decreases as the market level 3 rises (this result is less significant). Docking and Koch (2005) show that announcements to increase dividends tend to elicit greater positive abnormal returns when the market direction is normal or down and volatility is high and announcements to decrease dividends elicit significantly greater negative abnormal returns when market direction has been up and volatility is high i.e.…”

“…Previous empirical research focusing on asymmetries in reactions to company news can be roughly divided into three strands: asymmetry in reactions related to the tone of the news (Skinner, 1994;Skinner and Sloan, 2002;Alwathainani, 2010), asymmetry in reactions related to the state of the economy (Johnson, 1999) and asymmetry in reactions considering both the tone of the news and the state of the economy (Conrad et al, 2002;Docking and Koch, 2005;Livnat and Petrovits, 2009). Considering that previous research has generally focused only on one aspect of reaction asymmetry, this paper extends the literature by focusing on several aspects of reaction asymmetry simultaneously.…”

“…The only exception is Conrad et al (2002). However, their paper focuses on stock sentiment not on market sentiment.…”

The effect of investor sentiment on the means of earnings management

“…DIFFPE is the estimate of the overall level of equity market following Conrad et al (2002). It is based on the difference between the market price-to-earnings (P/E) ratio in the current month and the average market P/E over the previous 12…”

“…The empirical tests of this paper are based on investor sentiment (Baker & Wurgler, 2007) and the level of stock market (Conrad et al, 2002). Using a sample of public companies listed on Korea Securities Market from 2003 to 2011, the paper documents the following empirical test results.…”