What it means
Prices move when new information changes what investors think an asset is worth. A company announcing profits that are far above expectations may see its shares jump, while a disappointing result may cause them to fall.
The reaction is the market's verdict, delivered in price. What matters is surprise, not the news itself.
If analysts expected profits of $1.00 a share and the company reports $1.00, there may be little reaction, because the news was already in the price. Only the part that differs from expectations moves the market.
Analysts try to isolate the reaction by calculating the abnormal return, which is the actual return minus the return expected from general market movements. This helps separate the effect of company-specific news from a market-wide rise or fall.
Studies of reactions around announcements are a standard way of testing how quickly markets absorb information. Reactions can be short-lived or lasting.
Sometimes prices overreact and then partly reverse, and sometimes they underreact and drift in the same direction for weeks. Traders, risk managers and executives all watch the pattern to judge how much the market trusts a company.
The nuance is that a reaction is not always rational or fair. Thin trading, panic and herd behaviour can produce large moves that do not match the underlying facts.
Business leaders should avoid reading too much into one day's reaction and look at the longer trend. Timing also matters in how reactions are measured.
Analysts compare prices over a short window around the announcement, such as one day before to one day after, so that other news does not blur the result. A window that is too long picks up unrelated events, while one that is too short may miss a slower response.
In practice
Real-world examples.
Example
A retailer reports quarterly profit 20% above forecasts, and its share price rises 6% the next morning. The finance team notes that the reaction was stronger than for the previous quarter's beat. They interpret it as investors gaining confidence, and they plan to repeat the clear guidance that preceded the result.
Example
A central bank unexpectedly raises interest rates, and bank shares and bond prices fall within minutes. A treasurer reviewing the move sees that the market had priced in a smaller rise. The reaction measures the size of the surprise, and she updates her borrowing-cost forecast accordingly.
Example
A pharmaceutical company announces the failure of a drug trial, and its shares drop 30% in a day. Analysts compare this with the company's value to see if the drug accounted for that much. The reaction suggests investors believed the drug was worth even more, or that they now doubted the company's other projects too.
Formula
Calculation
Abnormal return = actual return - expected return
Percentage price reaction = ((price after - price before) / price before) x 100
A share trades at $80 before an earnings announcement and falls to $76.80 afterwards. The reaction is ((76.80 - 80) / 80) x 100 = (-3.20 / 80) x 100 = -4%. If the market was expected to move up 1% over the same period, the abnormal return is -4% - 1% = -5%.Case study
Seen in the real world.
Marlow Instruments is an illustrative, fictional listed company whose shares traded at $50. It announced a profit warning, saying earnings would be 10% below guidance, and the shares fell 8% in a day to $46.
The investor relations manager checked the market and found that other instrument makers had risen 1% that day, so the abnormal return was -8% - 1% = -9%. The reaction was bigger than the profit shortfall alone would suggest.
She arranged a call with analysts to explain that the shortfall was caused by a delayed shipment, not weaker demand. Over the next two weeks the share price recovered to $49. The illustrative lesson is that the market's first reaction can be an overreaction, and clear communication helps correct it.
Watch out
Common mistakes.
- Assuming good news always causes a price rise, when the reaction depends on whether it beat expectations.
- Ignoring the general market move and blaming a company for a fall that affected every share.
- Treating one day's reaction as the final judgement on a company's prospects.
Questions
People also ask.
Why do prices sometimes fall on good news?
Because the news may have been less good than investors expected, or the good news was already in the price.
What is an abnormal return?
It is the difference between the actual return and the return expected given general market conditions, and it isolates the effect of the news.
How long does a market reaction last?
It varies, since some reactions complete within minutes and others build or fade over days or weeks.
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