The cockroach theory refers to a market theory that states when a company reveals bad news to the public, many more related, negative events may be revealed in the future. Bad news may come in the form of an earnings miss, a lawsuit, or some other unexpected, negative event.
The term cockroach theory comes from the common belief that seeing one cockroach is usually evidence there are many more.
The cockroach theory is a nonscientific theory that is predicated on the idea that a company's fortunes are dependent on both external and internal forces, and may not just be affected by one piece of bad news. Put simply, when you see one cockroach, there may be many more you can't see right away. After all, one cockroach usually means there are more lying around in the dark.
So when a company is negatively affected by external forces, it is unlikely that its industry peers are immune to those same forces. Therefore, when one company's misfortunes are revealed to the public, it is likely that similar misfortunes will befall other similarly affected companies.
Earnings surprises or misses are indicators of industry trends, particularly if they occur for more than one company in an industry. If one isolated company in a sector shows an earnings surprise, it could be ignored. However, if more than one company announces an earning surprise or miss, it could be a strong indicator that other companies in the industry will have similar earnings results.