The Ricochet Effect of Bad News

Abstract

We study the information transfer effects of profit warnings issued by U.S. firms on domestic and international non-announcing firms during expansion and contraction periods. Profit warnings contain not only idiosyncratic information about the firm but also new information about the state of the sector. We estimate an information transfer effect of approximately 10% of the negative abnormal returns originated by U.S. firms on non-announcing firms in the U.S. market and 4% for international non-announcing firms. These findings show that the information transfers follow a ricochet effect, which means that the negative impact is larger for domestic non-announcing firms compared to international non-announcing firms. We also find significant transfer effects for international non-announcing firms, especially in the chemicals and petroleum, computer equipment, electronics, transportation and communication industries. Furthermore, we find empirical support that abnormal returns of profit warning announcements during expansion periods are more negative than during contraction periods. Investor confidence increases during expansion periods, and investors extrapolate good news for firms in general during expansion periods. Also, we find that extremely negative abnormal returns during expansion periods contain information that transfers to non-announcing firms. Our research shows that bad news during the expansion stage of the business cycle magnifies the reaction to bad news relative to the contraction stage.