Return Predictability and Trends in Earnings Surprises

• Main Authors: Warachka, Mitchell Craig, Loh, R.
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2006
• Subjects: Earnings Surprises; Underreaction; Trends; Finance and Financial Management; Portfolio and Security Analysis
• Online Access: https://ink.library.smu.edu.sg/lkcsb_research/1566
• Institution: Singapore Management University

We document that trends in firm-level quarterly earnings surprises predict returns. Trends require consistency between the sign of a firm’s most recent earnings surprise and its prior earnings surprises. The return predictability of trends is not induced by the relatively large earnings surprises that define post-earnings announcement drift. Instead, trends in prior earnings surprises explain more than half of post-earnings announcement drift’s risk-adjusted return. Our evidence indicates that investors underreact to trends and therefore provides partial support for Rabin (2002)’s theory that investor expectations are influenced by the law of small numbers.