Earnings Jolt Stocks Like Never Before as ETFs, Algos Get Blameby
Instances rise of big price swings after results are announced
Researchers see link to ascent of ETFs and passive investing
Just because U.S. corporate profit growth has ground to a halt doesn’t mean the impact of earnings announcements in the stock market has diminished. In fact, it’s never been bigger.
Swings such as Alcoa Inc.’s 11 percent plunge last week have become increasingly common since the financial crisis, according to a study by Leuthold Group that looked at how shares reacted in 193,000 instances going back to 1996. The Minneapolis-based fund manager found that earnings-day stock moves exceeding 5 percent doubled in seven years, even as the accuracy of analyst forecasts deteriorated only slightly and market volatility stayed the same.
Some investors pin the trend on the rise of computerized market makers whose hair-trigger algorithms have supplanted the deliberation of their human predecessors. To others, the swings are evidence not of a faster market, but a slower one. They say the likely culprit is the meteoric rise of passive index funds, which fail to appreciate differences among companies and their shares, throwing the process of price discovery out of whack.
“When earnings come out, it’s becoming a rockier road,” said Bill Schultz, who oversees $1.2 billion as chief investment officer of McQueen, Ball & Associates Inc. in Bethlehem, Pennsylvania. “You’re seeing more index-dominated movement and less retail participation in stocks than you have in the past.”
In an earnings season less than a week old, a handful of U.S. companies beyond Alcoa have already seen outsized price swings relative to recent history. On Oct. 13, First Republic Bank slipped 4.1 percent, the biggest post-earnings move since 2014 and almost double the historical average. Hasbro Inc. climbed 8.1 percent on Monday following its report, three percentage points more than the average throughout the bull market.
Index investments like exchange-traded funds have become an easy target for anyone trying to diagnose market anomalies if for no other reason than their rapid growth. More than $5 trillion is invested in passive strategies tracking stocks today, more than double the $2 trillion of five years ago, data from Morningstar Inc. show.
“With all the money flowing in, people are quick to point the finger at ETFs,” said Eric Balchunas, an ETF analyst with Bloomberg Intelligence. “It’s a relatively new variable on the scene and it gets tagged with a lot of problems. There are a couple of suspects, and maybe ETFs are one of them, but they’re not the only issue.”
While lots of things could contribute to bigger share reactions in the hours after a company discloses results, Leuthold found incomplete evidence in the accuracy of analyst forecasts or overall market volatility. Reported earnings differed from the consensus estimate by 11.3 percent between 2010 and 2016 compared with 9.7 percent from 2004 to 2007, it found, while instances of big moves on non-earnings days were the same.
Another possibility author Jun Zhu considered was tighter correlation among individual stocks, a hallmark of post-crisis trading in which economic headlines and concern about the failure of stimulus frequently send large swaths of the market reeling in unison. A measure of lockstep moves among S&P 500 stocks expressed as an average has held above 50 percent every day since 2007 after only crossing the threshold briefly between 2002 and 2004, at the start of the Internet bubble and after the crash of 1987.
“When stocks are more correlated for macro or sentiment reasons, most trading days they’ll move together, but when earnings release day arrives, some stocks have to ‘true up’ their prices to reflect individual fundamental performance rather than just floating along with the crowd,” Zhu wrote.
Explaining why the stock market has so often been transformed into a monolith of up-and-down motion since 2009 has been a hot topic among equity researchers. The simplest explanation is that the financial crisis so burned itself into investors’ psyches that every bad piece of economic data convinces them a repeat is at hand and they sell everything that isn’t nailed down.
The question isn’t settled, though, and some academics have implicated mutual and exchange-traded funds tied to equity indexes in dumbing-down the market.
That index-fomented correlation might play a part in post-earnings drift was the subject of a paper in December 2014 by Vijay Singal of Virginia Tech and colleague Nan Qin titled “Indexing and Stock Price Efficiency.” The authors examined a universe of 591 index funds to see if stocks that showed up the most often in them exhibited greater post-earnings drift. They did, the authors found -- in some cases almost twice as much.
According to Singal and Qin’s theory, earnings reactions are being altered because passive investing has damped market efficiency. Proportionately fewer traders are engaged in a day-to-day search for a trading edge in some stocks, so fewer signals about corporate performance seep into prices over time. Then they arrive all at once when results are disclosed.
“As indexing grows in popularity, there’s not that much incentive to watch the news or try to react to anything,” said Singal. “What results in a situation where there’s very little incentive to make prices efficient, which is why you see greater moves when there’s new information like earnings.”
Other measures of homogenization have increased in the last decade. Between 2013 through 2015, a measure known as dispersion -- or the degree to which one company in the S&P 500 resembles all others on a valuation basis -- hovered near a record, according to data compiled by Goldman Sachs Group Inc. It’s since reverted back close to average levels since 1990.
“While the passives drive the day-to-day moves, on earnings days, the active managers step in and react, playing a bigger role,” Michael O’Rourke, chief market strategist at JonesTrading Institutional Services LLC, said by phone. “That creates disconnects between fundamentals and prices, and there’s a lot of froth in there. The market isn’t efficiently repricing as it has historically.”