Winning is not enough: Changing landscapes of earnings surprises and the market reaction

Abstract

In this paper, we document strikingly opposite time-series patterns of earnings surprises and associated market reactions. Earnings surprises have increased over time, with the mean analyst forecast error (FE) rising from negative 1 to 2 cents in the 1990s to positive 1 to 2 cents in the 2010s, whereas the average earnings announcement returns have declined from 0.30% in the 1990s to -0.30% in the 2010s, turning negative in the past 17 years. Underlying the time-series pattern of increasing FEs is a secular trend where firms move away from just meet or small beat, to which the market reaction has become increasingly negative, towards a large beat, whereas the frequency of meeting or beating consensus analyst forecasts remains stable during the same period. We develop a parsimonious predictive model of FEs based on peer and past analysts’ forecast errors and find that our predicted FE closely mirrors reported FE, with the average value hovering around 1 to 2 cents in most years of the past two decades. The market reaction to “around-zero” unexpected FE (FE minus predicted FE) is indistinguishable from zero over time, suggesting that our model serves as a good benchmark of the market expectation. Our evidence has broad implications for appropriate earnings benchmarking, for a disappearing discontinuity in the earnings surprise distribution around zero, for earnings management to beat analysts’ forecasts, for empirical designs when examining the earnings-return relation, and for a disappearing earnings announcement premium.

Keywords: Analyst forecast, earnings surprises, earnings announcement returns, capital markets, discontinuity, management guidance JEL Classification: G30, G32, M21, M41

JEL Classification: G30, G32, M21, M41