The Party's Over: The Role of Earnings Guidance in Resolving Sentiment-Driven Overvaluation

Abstract

This paper shows that an important link between investor sentiment and firm overvaluation is optimistic earnings expectations, and that management earnings guidance helps resolve sentiment-driven overvaluation. Using previously identified firm characteristics, we find that most of the negative returns to uncertain firms in months following high-sentiment periods fall within the three-day window around the issuance of management earnings guidance. Comparisons of guidance months to nonguidance months show that guidance issuance affects the magnitude and not just the daily distribution of negative returns. There is also some evidence of negative returns around earnings announcements for firms that previously issued guidance, suggesting that guidance does not entirely correct optimistic earnings expectations. To provide additional insight into the strength of the guidance effect, we show that the market reacts more strongly to surprises, particularly negative surprises, following high-sentiment periods. Finally, firms with higher transient institutional ownership are less likely to guide, and their guidance is less likely to contain bad news following high-sentiment periods, indicating that managers with a short-term focus are hesitant to correct optimistic market expectations. THE PARTY'S OVER: THE ROLE OF EARNINGS GUIDANCE IN RESOLVING SENTIMENT-DRIVEN OVERVALUATION AbstractThis paper shows that an important link between investor sentiment and firm overvaluation is optimistic earnings expectations, and that management earnings guidance aids in resolving sentimentdriven overvaluation. Using the firm characteristics identified by Baker and Wurgler (2006), we find that most of the negative returns to uncertain firms in months following high sentiment periods fall within the three-day window around management earnings guidance issuance. Comparisons of guidance months to non-guidance months show that guidance issuance affects the magnitude and not just the daily distribution of negative returns. There is also some evidence of negative returns around earnings announcements for firms that previously issued guidance, suggesting that guidance does not entirely correct optimistic earnings expectations. To provide additional insight into the strength of the guidance effect, we show that the market reacts more strongly to surprises and particularly negative surprises following high sentiment periods. Finally, firms with higher transient institutional ownership are less likely to guide and their guidance is less likely to contain bad news following high sentiment periods, indicating that managers with a short-term focus are hesitant to correct optimistic market expectations.

Investor sentiment and management earnings forecast bias

“…It is generally more difficult to forecast earnings when uncertainty is higher. Consistent with this expectation, prior studies provide evidence that the influence of investor sentiment on stock valuation is stronger for ‘uncertain” or “difficult‐to‐value’ stocks (Baker & Wurgler, , ; Lemmon & Portniaguina, ; Mian & Sankaraguruswamy, ; Qiu & Welch, ; Seybert & Yang, ) and that analysts’ long‐horizon earnings forecasts are relatively more optimistic for ‘uncertain’ firms when sentiment is high (Hribar & McInnis, ). I thus expect that the influence of investor sentiment on management earnings forecast bias is more pronounced for firms with higher uncertainty and state my third hypothesis as follows: H3 :The positive association between investor sentiment and forecast bias in managers’ annual earnings forecasts is stronger for firms with higher uncertainty. …”

“…Qiu & Welch () validate the use of this index to measure investor sentiment by presenting evidence that the index is highly correlated with the UBS/Gallup survey of investor expectations of future stock market performance. In the past decade, the accounting literature has widely adopted the index as a measure for investor sentiment (e.g., Bergman & Roychowdhury, ; Seybert & Yang, ; Simpson, ; Walther & Willis, ). For denomination purposes, I divide the index by 100.…”

“…Furthermore, prior research finds that the influence of investor sentiment on stock valuation and analyst earnings forecast bias is larger for firms with higher uncertainty (Baker & Wurgler, , ; Hribar & McInnis, ; Lemmon & Portniaguina, ; Mian & Sankaraguruswamy, ; Qiu & Welch, ; Seybert & Yang, ). Since it is generally more difficult to forecast the earnings of firms with higher uncertainty, sentiment‐related management earnings forecast bias is likely to be more pronounced for firms with higher uncertainty.…”

Corporate Transparency and the Impact of Investor Sentiment on Stock Prices

“…Recent research has documented that investor sentiment plays an important role in explaining asset prices (e.g., Lemmon and Portniaguina 2006, Das and Chen 2007, Seybert and Yang 2012, Stambaugh et al 2012, Cen et al 2013. The sentiment effect varies across firms and may depend on 'noise trader risk' (Lee et al 1991, Kumar andLee 2006) and on the operating and financial characteristics of the firms.…”

“…Another way in which we extend the prior literature is that we use data from the world's largest emerging and transitional economy, namely, China. Research on investor sentiment has hitherto focused on developed and highly regulated markets such as the U.S. and the United Kingdom (e.g., Baker and Wurgler 2006, Seybert and Yang 2012, Gemmill and Thomas 2002. In contrast, there is little evidence available for emerging markets, which are vastly different from developed markets in terms of return volatility, ownership structure, investor protection, and corporate governance (Bekaert and Harvey 1997, Lemmon and Lins 2003, Leuz et al 2003.…”