Earnings Announcements, Order Flow, and Returns

Abstract

This paper is concerned with trading patterns around earnings announcements. We analyze order imbalances (buy orders less sell orders) following earnings surprises to determine if traders invest in a manner that is consistent with the representativeness heuristic (manifested by undue extrapolation of perceived patterns in random sequences). We then test whether such trading patterns affect returns. Our stimulus for this bias is a string of same-sign earnings surprises. Though not justified by subsequent price performance, we uncover evidence that investors extrapolate past trends in earnings performance. Specifically, following strings of consecutive positive earnings surprises, the amount of net buying after controlling for other regularities in trading activity is significantly greater than it is after an isolated positive surprise. This difference is increasing in the number of consecutive positive surprises in the string. Furthermore, subsequent to strings, purchasing activity is negatively correlated with returns throughout the remainder of the year.