Management Earnings Forecasts and Subsequent Price Formation

This paper examines price formation subsequent to management forecasts of quarterly earnings. Consistent with prior studies, we find that the short-term market reaction to bad news forecasts is much larger than that to good news forecasts. Examining returns in the post-guidance period, we find a significant upward drift for both good and bad news forecasts. The asymmetry in the initial market response and the subsequent upward drift in stock prices are consistent with a reversal of an initial overreaction to managers’ bad news forecasts and a continuation of an initial under-reaction to managers’ good news forecasts. This interpretation is supported by a negative (positive) relationship between the immediate market reaction and the post-guidance drift in the conservative (optimistic) group. The postguidance drift in turn is systematically associated with the market’s reaction to actual earnings announcements it attenuates investors’ response to surprises in actual earnings. Examination of the robustness of the post-guidance drift shows that it persists after controlling for risk-based corrections, calendar time clustering of announcements and stock price drifts associated with prior or subsequent actual earnings announcements. Trading strategies exploiting the post-guidance drift suggest the existence of economically significant trading profits, net of trading costs. Evidence of a positive relationship between the magnitude of the drift and changes in trading volumes and costs suggests information asymmetry during the event period as a potential determinant of the drift. However, the magnitude of the drift and the profitability of the trading strategies remain a puzzle. JEL Classification Code: G14, G30, M41