Asymmetric Investor Reaction around Earnings Benchmark under Economic Uncertainty

• DOI: http://doi.org/10.1111/ajfs.12246
• Date: 01 February 2019
• Author: Jae Eun Shin
• Published date: 01 February 2019

Asymmetric Investor Reaction around

Earnings Benchmark under Economic

Uncertainty*

Jae Eun Shin**

Institute for Business Research and Education, Korea University Business School, Republic of Korea

Received 11 February 2018; Accepted 1 November 2018

Abstract

This study examines the effect of macro-economic shocks on asymmetric investor reactions

to earnings announcements. Specifically, we focus on a small range around the earnings

benchmark and find a disproportionately large market penalty for firms with small negative

earnings surprises (ESs) following an increase in macro-uncertainty. By contrast, we find no

evidence of an asymmetric market reaction to firms with small negative ESs following a

decrease in macro-uncertainty. While prior empirical research failed to document the large

penalty for small negative ESs, our findings suggest macro-economic shocks as a factor that

explains the asymmetric pricing effect.

Keywords Macro-economic uncertainty; Earnings benchmark; Investor reaction

JEL Classification: G10, G14, M40

1. Introduction

This study focuses on the effect of macro-uncertainty shocks on investor

responses around the earnings benchmark. Prior anecdotes in the press cite that

investors place a disproportionately large penalty on firms that report small neg-

ative earnings surprises (ESs). For instance, Skinner and Sloan (2002) refer to

the drop in stock prices for firms that miss analyst forecasts as the earnings

“torpedo” effect and cite three anecdotes pertaining to small negative ESs.

1

In

*This paper is revised from the author’s Ph.D. dissertation. The author would like to thank

Kee-Hong Bae (editor), two anonymous referees, and the dissertation committee: Seungmin

Chee (chair), Manwoo Lee, Jinbae Kim, Wooseok Choi, and Kwang J. Lee.

** Corresponding author: Korea University Business School, 145, Anam-Ro, Seongbuk-Gu,

Seoul 02841, Republic of Korea. Tel: +82-2-3290-2704, email: jaeeun84@gmail.com.

1

Skinner and Sloan (2002) cite the examples of Oracle, Intel, and Home Depot as evidence of

stock price drops after the announcement of small negative ESs. However, in a discussion

paper on Skinner and Sloan (2002), Hand (2002) criticizes the results in that the asymmetric

price reaction does not kick in until the absolute magnitude of the ES exceeds a certain range

(0.7% of the stock price).

Asia-Pacific Journal of Financial Studies (2019) 48, 98–122 doi:10.1111/ajfs.12246

98 ©2019 Korean Securities Association

line with the disproportionately large market penalty on small, negative ESs,

extant accounting literature provides evidence of managers taking action to just

meet or barely beat analyst forecasts to avoid a negative market reaction

(Matsumoto, 2002; Burgstahler and Eames, 2006). In addition, in a survey study,

Graham et al. (2005) indicate that CFOs fear missing the benchmark by small

amounts as it may lead investors to doubt the firm’s prospects and/or managers’

abilities. However, in contrast to this prior anecdotal and survey evidence,

empirical research largely failed to document this asymmetric pricing effect

(Frankel et al., 2010; Payne and Thomas, 2011).

2

In this study, we attempt to

reconcile the discrepancy between the anecdotal and/or survey evidence and the

empirical findings by introducing macro-economic uncertainty as an external

factor that may affect asymmetric investor reactions around the earnings

benchmark.

Macro-economic uncertainty creates an unfamiliar environment for investors

and may directly affect how investors react to corporate earnings announcements

(Epstein and Schneider, 2008). Epstein and Schneider (2008) show that because

investors are averse to uncertainty, they adopt a pessimistic bias by reacting to

bad news, but largely ignore good news during times of high market uncertainty.

In line with this prediction, Williams (2015) and Bird and Yeung (2012) show

evidence that investors react asymmetrically and place more weight on negative

earnings news than on positive earnings news following an increase in macro-

uncertainty. On the other hand, Stein and Wang (2016) find a lower stock price

reaction to ESs in uncertain times, regardless of whether the ES is positive or

negative, and interpret this result as investors attributing bad (good) performance

to bad (good) luck rather than less (more) managerial effort during uncertain

periods.

3

They further find evidence of managers shifting earnings from uncertain

to more certain times.

A common feature of most prior studies examining investor reactions to ESs is

that they aggregate small and large ESs in their regression analyses, even when the

region of interest is a small range around the earnings benchmark. This regression

method can confound the interpretation of the results, especially when the market

2

Prior studies indicate the lack of empirical support on the disproportionate market penalty

for small negative ESs. For instance, Frankel et al. (2010, p. 220) state that “Anecdotal and

survey evidence suggest that managers take actions to avoid small negative earnings surprises

because they fear disproportionate, negative stock-price effects. However, empirical research

has failed to document an asymmetric pricing effect.”

3

For the measurement of uncertainty, Stein and Wang (2016) use the firm-level implied

volatility of options on the last day of the fiscal period. In this study, we focus on macro-

uncertainty shocks and use the increase in the volatility index just before the earnings

announcement. (See Section 3.2 for the measurement of uncertainty shocks.)

Asymmetric Investor Reaction

©2019 Korean Securities Association 99