Investor (Mis)Reaction, Biased Beliefs, and the Mispricing Cycle

Abstract

We construct a new measure that captures the disparity between the market reaction to earnings information and the earnings surprise ("Return-Earnings Gap", "REG"). High REG positively predicts analyst forecast errors and a build-up of firm mispricing (overvaluation) over several quarters. Future analyst errors are particularly increased and accompanied by stronger mispricing when REG provides confirming information. A simple model for the dynamic expectation formation between different market participants corroborates these findings. Overall, our results reveal how the market’s (mis)reaction feeds back into the belief formation of analysts and investors, leading to a slow correction of firm mispricing.

Keywords: investor beliefs, analysts, analysts’ expectations, mispricing, misreaction, anomalies

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