Investments, tenth edition

 Figure 11.4 

Average return as a function of book-to-market ratio, 

1926–2011  

 Source: Authors’ calculations, using data obtained from Professor Ken French’s data library 

at   http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.     

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P A R T   I I I

  Equilibrium in Capital Markets

 The “news content” of an earn-

ings announcement can be evaluated 

by comparing the announcement of 

actual earnings to the value previ-

ously expected by market partici-

pants. The difference is the “earnings 

surprise.” (Market expectations of 

earnings can be roughly measured 

by averaging the published earnings 

forecasts of Wall Street analysts or 

by applying trend analysis to past 

earnings.) Rendleman, Jones, and 

Latané  

35

   provide an influential study 

of sluggish price response to earn-

ings announcements. They calculate 

earnings surprises for a large sample 

of firms, rank the magnitude of the 

surprise, divide firms into 10 deciles 

based on the size of the surprise, and 

calculate abnormal returns for each 

decile.  Figure 11.5  plots cumulative 

abnormal returns by decile.

   

 

Their results are dramatic. The 

correlation between ranking by earn-

ings surprise and abnormal returns 

across deciles is as predicted. There 

is a large abnormal return (a jump 

in cumulative abnormal return) on 

the earnings announcement day 

(time 0). The abnormal return is pos-

itive for positive-surprise firms and 

negative for negative-surprise firms. 

 The more remarkable, and interesting, result of the study concerns stock price move-

ment  after  the announcement date. The cumulative abnormal returns of positive-surprise 

stocks continue to rise—in other words, exhibit momentum—even after the earnings 

information becomes public, while the negative-surprise firms continue to suffer negative 

abnormal returns. The market appears to adjust to the earnings information only gradually, 

resulting in a sustained period of abnormal returns. 

 Evidently, one could have earned abnormal profits simply by waiting for earnings 

announcements and purchasing a stock portfolio of positive-earnings-surprise companies. 

These are precisely the types of predictable continuing trends that ought to be impossible 

in an efficient market.