Investor Sentiment and the Market Pricing of Corporate Earnings

This study examines whether the market pricing of corporate earnings is affected by investor sentiment. The primary proxy of investor sentiment in this paper is the composite index developed by Kim and Byun (2010), based on common variation in six underlying proxies of sentiment (the share turnover in Korea Stock Exchange, equity share in new issues, retail investors’ trading, stock fund flows, Customer Expectation Index, and customer’s deposit for stock investment). In order to capture stock price reaction to earnings news, I measure the earnings response coefficient (ERC) and post-earnings announcement drift (PEAD) based on cumulative and buy-and-hold abnormal returns over windows [-1,+1] and [+2,+60], respectively, where day 0 is quarterly earnings announcement date. Using a sample consisting of 12,012 quarterly earnings announcements of listed companies on Korean Securities Market over the years 2001 to 2010, I find that the effects of investor sentiment on stock price reaction to good and bad earnings news are differential. I show that ERC and PEAD for positive earnings surprise do not vary with investor sentiment. By contrast, bad news response coefficient is lower when investor sentiment is pessimistic than when it is optimistic. This indicates that market participants react less negatively to negative earnings surprise when they are pessimistic. I also show that post-bad-news-announcement drift over window [+2,+60] is less negative when sentiment is pessimistic, suggesting that the impact of investor sentiment on the pricing of bad earnings news does not reverse quickly. Additional analysis shows that the results are robust to an alternative measure of investor sentiment based on the aggregate market price-to-earnings ratio.