Mind the Gap: The Non-Fundamental Role of Earnings Days

Abstract

We construct a new measure—the Return-Earnings Gap (REG)—that captures the market's relative (mis)reaction to earnings surprises. About 50% of the earnings-day return associated with REG reverses subsequently, with the reversal being strikingly slow, taking about three years. REG feeds back into and distorts market participants’ belief formation, predicting subsequent analyst forecast errors, corporate actions associated with mispricing, and the divergence of anomaly returns. A simple structural model of market participants’ expectation formation corroborates these findings. Our results show that earnings-day returns contain a substantial non-fundamental component with long-term effects, contrasting with the predominant fundamental view of earnings days.

Keywords: investor beliefs, earnings announcements, misreaction, analyst expectations, mispricing, anomalies

JEL Classification: G00, G12, G14, G40, G41