Ebook Market and Analyst Reactions to Earnings News: an Efficiency Comparison
This study compares the efficiency at which the stock market and financial analysts react to corporate earnings announcements. A primary motivation for this comparison is that analysts are important information intermediaries in the stock market, implying that understanding of financial analysts’ behavior is a crucial component in the understanding of the price formation process. We choose corporate earnings announcements as the setting for comparison because earnings announcements are among the most significant recurring public information releases by corporations.
Financial analysts are important players in the stock market. They collect, process and aggregate information from diverse sources, communicate it to investors in concise forms such as earnings forecasts and stock recommendations. It has long been argued that financial analysts are not perfect information intermediaries because they tend to be too optimistic, over-react to some information, and under-react to other information. Suggested causes of these imperfections include conflict of financial interest due to analysts’ dual roles in investment banking and equity research, inexperience and cognitive biases, and herding behavior. Analysts’ role in the recent stock market bubble and high profile corporate scandals further reinforces the notion that analyst earnings forecasts and stock recommendations do not efficiently reflect value relevant information.
The stock market, on the other hand, is generally believed to be quite efficient with respect to public information. Many scholars of financial markets regard the efficient markets hypothesis as a cornerstone in modern financial economics. Despite the large volume of literature that documents empirical regularities in stock prices that seem to violate semi-strong form market efficiency, most are convinced that market inefficiencies are the exception, rather than the rule. Even documented market anomalies are often shown difficult to exploit in reality once transactions costs and risk factors are fully considered.
Given the above considerations, one might intuitively conjecture that in the reaction to earnings news, the market would likely show higher efficiency or greater speed than analysts. Further supporting this conjecture is the prospect that market participants have their own money on the line while analysts are only indirectly affected by how they react to new information through complex compensation structures. However, to date, the literature does not support this conjecture. In their study of post earnings-announcement drift, Abarbanell and Bernard (1992) found under-reaction to earnings announcements by both analysts and the market, but concluded that the market under-react more than analysts because analyst under-reaction cannot fully account for post-announcement price drift. Alford and Berger (1997), and Brous and Shane (2001) found similar evidence, though the latter paper concluded that Abarbanell and Bernard had under-estimated the amount of post-announcement drift that can be accounted for by analyst under-reaction.
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