Investor Overreaction to Earnings Surprises and Post-Earnings-Announcement Reversals
63 Pages Posted: 2 Oct 2016 Last revised: 30 Aug 2018
Date Written: September 23, 2016
Prior literature suggests that the market underreacts to the positive correlation in a typical firm’s seasonal earnings changes, which leads to a post-earnings-announcement drift (PEAD) in prices. We examine the market reaction for a distinct set of firms whose seasonal earnings changes are uncorrelated and show that the market incorrectly assumes that the earnings changes of these firms are positively correlated. We also document that positive (negative) seasonal earnings changes in the current quarter are associated with negative (positive) abnormal returns in the following quarter. Thus, we observe a reversal of abnormal returns, consistent with a systematic overreaction to earnings, rather than the previously documented PEAD. Additional analysis indicates that financial analysts similarly overestimate the autocorrelation of these firms, although to a lesser extent. We also find that the magnitude of overestimation and the subsequent price reversal are inversely related to the richness of the information environment. Our results challenge the notion that investors recognize but consistently underestimate earnings correlation and provide a new perspective on the inability of prices to fully reflect the implications of current earnings for future earnings.
Keywords: Earnings surprises, Investor overreaction, Post-earnings-announcement reversals, Market anomaly
JEL Classification: M41, G12, G14
Suggested Citation: Suggested Citation