Earnings Surprises and Future Stock Market Returns

As espoused by many market commentators, do positive (negative) earnings surprises in fact predict upward (downward) stock market movement? In their January 2010 paper entitled “Aggregate Market Reaction to Earnings Announcements”, William Cready and Umit Gurun investigate the relationship between earnings announcement surprises and market returns, focusing on the days surrounding earnings news. Using quarterly earnings announcements for a broad sample of firms spanning January 3, 1973 through June 21, 2006 (413,687 announcements) and contemporaneous values of a combined NYSE/AMEX index, they find that:

• Aggregate earnings levels are unrelated to contemporaneous market returns.
• However, positive (negative) surprises in aggregate earnings indicate downward (upward) future movements in aggregate market value, concentrated in the days immediately surrounding earnings releases. This relationship implies that aggregate earnings surprises drive changes in expectations about the market discount rate that swamp any changes in expectations about future aggregate cash flow.
• Consistent with this interpretation, aggregate earnings surprises relate positively to movement in short and long-term bond yields.
• Less than half the impact of aggregate earnings surprises on overall market returns occurs during the immediate announcement period. Depending on the measures used, 60% to 75% of the impact from day -2 through day +100 relative to announcement date occurs after day +3 (see the chart below).

The following chart, taken from the paper, graphs measures of the average relationship of aggregate earnings surprises to cumulative market returns from day -20 through day +100 relative to earnings announcement (day 0) for different combinations of equal and value weighting of earnings and returns. As noted above, the relationship is negative, so positive (negative) surprises indicate negative (positive) future returns. Results reveal a post-announcement market return drift that is greater than the immediate impact of an aggregate earnings surprise.

In summary, evidence indicates that positive (negative) aggregate earnings surprises portend higher (lower) future inflation/discount rates, and therefore negative (positive) future stock market returns and increases (decreases) in bond yields.

In other words, while positive (negative) earnings surprises may boost (tank) the stocks of individual companies, in aggregate, they tend to raise (lower) the discount rate bar for all stocks.

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