Why Did Stock Prices Decline After An Earnings Surprise?

What caused stock prices to recently decline after an earnings surprise?

As mentioned in a recent blog post, Q2 2017 earnings was generally positive. Year over year growth was 10%, and there was a wide range of earnings surprise. There was one anomaly, however, that puts a slight damper on the Q2 story.

There were plenty of companies that reported earnings surprises. In fact, seven times more companies reported a positive surprise than a negative surprise. This is the hallmark of a very good quarter. However, the stock market, which usually rewards the market after an earnings surprise, actually drove the companies’ stock price slightly negative on average. In other words, a good earnings report was greeted with the stock price decreasing (this is also known as negative price impact). How odd is that fact? The last time this had happened was 25 quarters ago.

What could drive this phenomenon? Here are a few theories:

1. The market has very rich valuations

If you look at the forward Price Earnings Ratio, the market is currently priced at 17 times earnings. This ratio usually hovers around 14-15, so the market has priced in forward-looking “good” news. On a company level, this includes earnings. When a company reports earnings, the market expects the company to beat earnings—so it generally isn’t viewed as highly. Basically, with growth priced into the company’s valuation, unless it is a major earnings beat, the market is not impressed.

2. The market itself was stagnating

As we entered 2017, the market was expecting continued to slightly increased economic growth. It was expecting the new presidential administration to roll back regulations, decrease taxes, increase defense spending, and expand infrastructure spending. In Q2, all of sudden, the market has begun to reassess and pull back from these expectations. So, even when companies report good news, they can still be overtaken by macro winds.

3. Earnings surprises have become far more commonplace

As I mentioned, it was seven times more likely that a company had a positive surprise than an earnings miss. In prior quarters, the market may have rewarded surprises more.

Regardless of the reason, small to negative price impacts will hurt overall market performance if this persists. Watch the earnings season in Q3 to see if declines after an earnings surprise continues. If so, it will be very hard for the market to continue upward growth.