Practice Question
Nicholas Manufacturing just announced yesterday that its fourth quarter earnings will be 10% higher than last year's fourth quarter. You observe that Nicholas had an abnormal return of -1.2% yesterday. This suggests that:
A) the market is not efficient.
B) Nicholas' stock will probably rise in value tomorrow.
C) investors expected the earnings increase to be larger than what was actually announced.
D) investors expected the earnings increase to be smaller than what was actually announced.
E) earnings are expected to decrease next quarter.
Answer +
Correct Answer:
C) investors expected the earnings increase to be larger than what was actually announced.
C) investors expected the earnings increase to be larger than what was actually announced.
Explanation +
- Observation of Abnormal Return: Despite Nicholas Manufacturing announcing a 10% earnings increase, the stock fell by 1.2%.
- Efficient Market Hypothesis (EMH): Under EMH, prices reflect all available information. Any reaction is a reflection of new, unexpected information.
- Market Expectations: The negative return implies disappointment — investors were expecting an even higher increase than the 10% announced.
- Conclusion: The market had anticipated more than 10% growth, and the stock reacted negatively when expectations weren't met.