Ebook Short Sale Constraints, Heterogeneous Interpretations, and Asymmetric Price Reactions to Earnings Announcements
Earnings announcements are among the most important information events by which firms disclose information to the market. Accounting research provides extensive evidence that earnings announcements convey important information for security valuation. It has also been well recognized that deriving the valuation implications of earnings signals is complicated, even for sophisticated financial analysts. This complexity leaves ample room for disagreement among investors in interpreting earnings signals. The effect of heterogeneous interpretations of earnings signals on the price reactions to earnings announcements has not received much attention. The lack of attention probably reflects the traditional view that, although disagreement on the public information generates trading activity, these trades are idiosyncratic and hence offset the effects of one another, thus having no consequences for average prices (Hong and Stein 2007). Building on the insights of recent theoretical literature on the pricing effects of short sale constraints, this study examines the effect of heterogeneous interpretations of earnings signals on the price reactions to earning announcements.
Two recent empirical studies have investigated the effects of short sale constraints on the price reactions to earnings announcements. Reed (2007) shows that stocks for which short selling is particularly costly have larger price reactions to earnings announcements, especially to bad news. He suggests that this evidence confirms Diamond and Verrechia’s (1987) hypothesis that short sale constraints reduce the speed with which prices adjust to private (especially negative) information. Berkman et al. (2009) document that stocks with a greater difference of opinion prior to earnings announcements earn lower returns around these announcements, and this pattern is more salient within the subsample of stocks that are more difficult for investors to sell short. Their evidence suggests that overvaluation exists under short sale constraints, which is consistent with Miller’s (1977) overpricing hypothesis, and earnings announcements narrow the differences of opinion, hence reducing overvaluation.
The focus of Reed (2007) and Berkman et al. (2009) is on the effect of earnings announcements in enhancing agreement by mitigating the information asymmetry or differences of opinion that exist prior to the announcement event. Reed (2007) regards earnings as private information until a public announcement is made. Berkman et al. (2009) argue that although differences of opinion among investors about stock value may not be completely eliminated after earnings announcements, they are reduced. Neither Reed (2007) nor Berkman et al. (2009) consider price reactions to earnings announcements conditional on the degree of heterogeneity in the interpretations of the earnings news. In this study, we extend the existing analysis by incorporating the effect of heterogeneous interpretations of earnings news. Interestingly, we find that the earlier conclusion is reversed when significant heterogeneous interpretation is present.
The literature on heterogeneous interpretations of information and the literature on short sale constraints have largely evolved separately. The literature on heterogeneous interpretations focuses on the possibility that public information may trigger different interpretations, which leads to different opinions and stimulates trading. The extensive studies on short sale constraints assume that differences of opinion exist and are reduced over time; as a result, overvaluation is corrected over time. A recent study, Xu (2007), joins these two lines of research and analyzes how heterogeneous interpretations of public signals contribute to overvaluation. Xu (2007) extends Miller’s (1977) intuition to the setting of stock price reactions to public announcements.
One key prediction of his study is that heterogeneous interpretations among investors, when coupled with short sale constraints, do not offset the effects of one another. Instead, they affect equilibrium prices. In particular, Xu (2007) predicts that the selective registration of more optimistic opinions under short sale constraints implies stronger price reactions to good news than to bad news, and this asymmetry increases with the degree of interpretation heterogeneity and short sale constraints.
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