The 2-Minute Thought: Extreme Stock Price Reactions

Recently, there have been some pretty extreme stock price reactions after earnings announcements.

Why would Chinese test prep company New Oriental Education trade down by 17% after announcing a negative 2% earnings surprise -- while the shares of apparel company VF Corp see a drop of 11% on a 9% positive earnings surprise and higher guidance? Why would Vulcan Materials jump more than 22% on a 2.4% positive surprise? And why would Caterpillar fall almost 8% after meeting earnings expectations but seeing a modest decline in backlog?

It’s hard to make sense of it all – and perhaps fruitless to try.

According to FactSet, a positive earnings surprise usually leads to a 1% rise in the company’s stock price. But as of the end of last week, the average earnings “beat” sent stock prices down by 1.5%. We haven’t seen such negative responses to positive reports since 2011 – and if you remember 2011 like I remember 2011, that was a hard year.

Obviously, a single quarter is only a single quarter. But this is weird.

The Financial Times wrote this morning that S&P 500 companies are on track to reporting average earnings growth of more than 26% -- and that more than 75% of the companies that have reported results so far have exceeded expectations. But good results haven’t counted for much this quarter. And companies that haven’t met expectations have gotten severely punished. That means that double digit percentage declines in a single day have been pretty common.

The popular narrative is that stocks – and all asset classes – are getting re-rated in light of tariffs, China, inflation, and the possibility that economic growth and earnings are peaking in the U.S. Those all seem like good reasons to reassess stock valuations. But in truth, there is very little clarity yet on what is going on – nor is there ever much clarity when it comes to short-term stock price movements.

In his blog this week, NYU finance professor Aswath Damodaran looked at the most common explanations that have been put forth for October’s market chaos. They include the Fed raising interest rates, a technology meltdown, a correction in overvalued stocks, an end to U.S. economic outperformance versus the world, and just plain old panic. But there wasn’t enough evidence behind any of these explanations to say anything definite.

In addition, Damodaran found that stock declines in October happened regardless of valuation. The idea that “overvalued” stocks would decline more than “undervalued” ones just didn’t play out.

That is a reminder that short-term stock price movements have a lot of noise in them and probably are best ignored. In the short term, prices are a puzzle. And while things will get sorted out longer-term, we know far too little to do anything yet except pause and take a breath.

If we are seeing individual stock prices decline 10% or 20% or sometimes even more in a single day, and those declines don’t make sense in light of the new information being released – well, that suggests that either the price was quite wrong before the announcement or that the extreme reaction after the announcement is. But since we don’t yet know which of those is true, take that breath . . . and hold on.