Back in March, I wrote about a study which showed trading on the "soft" information -- as opposed to the hard numbers -- contained in news stories on company earnings could be a profitable strategy.
There are two reasons for this:
- The sentiment conveyed in earnings announcements is harder to process than stats like profit margin, free cash-flow, debt level, etc.
- The analysts who do a good job of passing on the information about the hard numbers to clients don't do as well with words.
Because of this inability to process textual information quickly, stocks can move for days, weeks, or months after an earnings release even when there's no additional substantive news about the company's prospects, a phenomenon called the the Post-Earnings Announcement Drift. At least that's how the theory and the evidence we've seen so far tells us.
Now, a new Federal Reserve working paper by Elizabeth Demers and Clara Vega takes the investigation one step further and looks at how prices move based off earnings releases themselves and not just news stories. After investigating movements for about 6,300 firms between 1998 and 2006, they reach a conclusion similar to the previous, but sparse, research:
Consistent with the view that soft information is more difficult for market participants to process, we find that it takes longer for soft information than for hard information to be incorporated into prices.
Unlike past research, Demers and Vega also look at the amount of certainty contained in a news release. To do this, they use a computer program to look for words that showed resoluteness and inflexibility. For example, one biotech firm had a high uncertainty score because of language used surrounding the potential outcomes of clinical trials and drug approval processes. (The paper's Appendix has other examples of earnings announcements and the words that were tagged by the program.)
They find that, on average, companies with more uncertain earnings statements tend to see more volatility in their stocks, or in other words, the more wishy-washy a company comes across, the more its stock price will bounce around.