During earnings announcement season, stocks regularly make big moves up or down depending on how announced earnings compared with market expectations. "Why are market expectations sometimes so wrong?" is a common question I here asked.
Markets may not be wrong and still make big moves on earnings announcements. A market is pricing expected future cash flows, and these expectations are over many states of the world and involve many different probabilities. When management announces earnings, a state of the world is realized and the market updates to the new world. The new world has different expected future cash flows and different probabilities for states of the world.
A large price swing can result for a number of reasons. First, the company may announce a state of the world the market believed only had a low-probability of materializing. Second, states of the world may be very different. If a company faces two states of the world - succeed or bankrupt - then knowing the company succeeded will boost the stock price significantly even if the market was 90% sure the state of the world would be succeed.
Still why is the market so uncertain about the states of the world? There are at least three sources of uncertainty. One source is systematic uncertainty. How well is the overall economy doing? How likely is trade to be shut down due to political turmoil? Another source of uncertainty is industry related. How will this industry fare relative to the performance of other industries? Is there a disruptive technology? Finally, there is idiosyncratic uncertainty. How well will management increase profitability by improving plant operations? How much money will management consume for private benefits instead of distribute to shareholders?
Hedge funds and investors are actively trying to discover information and price the information into the market. Still, the amount of variables in motion to learn about presents a staggering amount of information to consider.
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