Investor Overreaction to Earnings Surprises and Post-Earnings-Announcement Reversals

Posted: 21 May 2019

See all articles by Allen W. Bathke

Allen W. Bathke

Florida State University - Department of Accounting

Terry Mason

Kansas State University

Richard M. Morton

Florida State University - Department of Accounting

Multiple version iconThere are 2 versions of this paper

Date Written: November 7, 2018

Abstract

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. That is, we show that investors predictably overestimate correlation when it is lacking but underestimate it when it is present.

Keywords: Earnings surprises, Investor overreaction, Post-earnings-announcement reversals, Market anomaly

JEL Classification: M41, G12, G14

Suggested Citation

Bathke, Allen W. and Mason, Terry and Morton, Richard M., Investor Overreaction to Earnings Surprises and Post-Earnings-Announcement Reversals (November 7, 2018). Contemporary Accounting Research, Forthcoming. Available at SSRN: https://ssrn.com/abstract=3379861

Allen W. Bathke (Contact Author)

Florida State University - Department of Accounting ( email )

419 Rovetta Business Building
Tallahassee, FL 32306-1110
United States
850-644-7888 (Phone)

Terry Mason

Kansas State University ( email )

Manhattan, KS 66506-4001
United States

Richard M. Morton

Florida State University - Department of Accounting ( email )

Room No. 421
Tallahassee, FL 32306-8234
United States
850-644-7877 (Phone)

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