Stock Price Response to Earnings News in India: Investors’ Learning Behaviour under Uncertainty

This research paper examines the association of inter-temporal variation in stock price response to quarterly earnings surprise in India with relevant indicators of changes in fundamental conditions. Earnings response coefficients are higher during periods when the economic conditions indicate lower systematic risk and higher growth prospects, consistent with asset pricing theory. However, there are differing asymmetric effects of good and bad earnings news depending upon recent market and macro-economic conditions, especially for stocks associated with greater information uncertainty. We conclude that the evidence from earnings response supports predictions of rational models of investors’ learning behaviour under uncertainty.


In this research paper, we examine the influence of changing macro-economic conditions on stock market reaction to quarterly earnings news for a sample of actively traded stocks in India. We test two hypotheses in this paper. First, the earnings response coefficient (ERC, the elasticity of stock price return to earnings surprise) should increase directly with improving economic growth prospects and decline in interest rates. We call this equity valuation effect, since the equity valuation models equate fair value of a stock directly with future cash flows and inversely with discount rates. Extending the present value equation, and assuming that the earnings process has persistence, it can be analytically established that the earnings response coefficient would be an increasing function of the expected growth opportunities and a decreasing function of the discount rate (Collins and Kothari 1989).

Second, we expect that the effect of changes in market conditions should result in asymmetric earnings response due to investors’ learning process depending upon whether the new earnings information is consistent or inconsistent with the market trends. When market conditions improve, the response would be greater for firms announcing bad earnings news but lesser for firms announcing good earnings news, and vice versa when market conditions worsen. We call this learning effect hypothesis, and it can be explained using rational models of learning under uncertainty, for example, the regime-shift model of Veronesi (1999) or the model of learning under parametric uncertainty of Lewellen and Shanken (2002).

Collins and Kothari (1989) empirically validated that the earnings response coefficients are positively associated with rising earnings growth and earnings persistence, but decline with increase in the risk free rate. Johnson (1999) confirmed the direct relationship of earnings response with business cycles.

Conrad, Cornell and Landsman (2002) empirically validated the regime shift effect, which is based on investors’ learning behaviour, for the US market. In the same paper, the authors showed that market response to bad earnings news is greater under relatively good market conditions, and conversely, the market response to good earnings news is greater under relatively bad market conditions, the relative conditions being defined by comparing the current conditions with the average over the past 12 months.

However, the learning effect has not been tested so far in an emerging market context and this paper is the first to examine whether the investor response to earnings news in India is associated with time variation due to changing valuation, and also whether there is evidence of investors’ learning behaviour under uncertainty.

In order to test the two hypotheses for the Indian market, we identify seven relevant proxies based on previous research that establish the relationship between stock returns and business cycle indicators. The selected variables include growth in the index of industrial production, revision in economic growth forecasts, short term Treasury Bill rates, term structure of interest rates and three price multiples – the price to earnings ratio, the price to dividend ratio and the price to book value ratio. Previous research has established the relationship of stock prices with the index of industrial production (Pethe and Karnik 2000) and interest rates (Panda 2008) in India.

As summary measures, we build an index of market conditions (COND) using average standardized values of these proxies and an index of relative market conditions (RCOND) using average cyclical changes in these proxy measures.

We find clear evidence of equity valuation effect. The monthly ERCs based on cross-sectional regressions have a statistically significant correlation across proxies of market conditions and a Pearson’s product moment correlation of 0.51 with COND. In regressions using larger sample of pooled data, we find that the ERCs under strong COND are nearly four times as high as those under weak COND in the case of both good and bad earnings news, consistent with the equity valuation effect.

We also test the learning effect with changing market conditions, and our conclusions support the regime shift model. Analysing the effect of conditions relative to the average of the previous 12 months, using RCOND index, which is derived from the COND index, we find that ERCs in case of bad news under improving relative conditions are more than four times as high as when conditions are worsening, but the difference is statistically insignificant in the case of good news due to the offsetting effect of rise in the discount rate, consistent with the predictions of the regime shift model.

The learning effect is expected to be higher for firms where information flow is constrained. Consequently, we also test the effect of relative market conditions across firms by characteristics such as size, analyst coverage and stock return volatility. We find that the learning effect indeed becomes stronger in the case of stocks which are smaller, have lower analyst coverage, and have more volatile returns.

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