Market Insights and Market Oversights on Firms for which Earnings Follow a Seasonal Random Walk Process

The post-earnings-announcement-drift (PEAD) literature suggests that the market underreacts to the commonly observed positive correlation in firms’ seasonal earnings changes, which leads to a subsequent drift in stock prices. We examine the market reaction for a distinct set of firms whose seasonal changes in quarterly earnings are uncorrelated. We document that the market acts as if the seasonal earnings changes of these firms are in fact correlated, consistent with an overreaction. We also show that positive (negative) seasonal earnings changes in the current quarter are associated with negative (positive) abnormal returns in the following quarter. That is, rather than finding the more typical PEAD, we observe a reversal of abnormal returns. Additional analysis indicates that these results are primarily driven by firms with relatively poor information environments. Our results provide a unique perspective on the inability of prices to fully reflect the implications of current earnings for future earnings.

This seminar is organised by the Erasmus Accounting Research Group.