Tests of Analysts' Overreaction/Underreaction to Earnings Information as an Explanation for Anomalous Stock Price Behavior

TLDR

The feature of analysts’ forecasts aligns with properties of the naive seasonal random walk forecast that Bernard and Thomas (1990) propose underlies the well‑known post‑earnings‑announcement drift. This study examines whether security analysts underreact or overreact to prior earnings information and whether such behavior could explain previously documented anomalous stock‑price movements. Analysts’ forecasts underreact to recent earnings, but the magnitude of underreaction is only about half what would be needed to explain the post‑earnings‑announcement drift, and extreme forecasts are not linked to stock‑price overreactions, indicating that analysts’ behavior only partially explains stock‑price underreaction to earnings.

Abstract

ABSTRACT This study examines whether security analysts underreact or overreact to prior earnings information, and whether any such behavior could explain previously documented anomalous stock price movements. We present evidence that analysts' forecasts underreact to recent earnings. This feature of the forecasts is consistent with certain properties of the naive seasonal random walk forecast that Bernard and Thomas (1990) hypothesize underlie the well‐known anomalous post‐earnings‐announcement drift. However, the underreactions in analysts' forecasts are at most only about half as large as necessary to explain the magnitude of the drift. We also document that the “extreme” analysts' forecasts studied by DeBondt and Thaler (1990) cannot be viewed as overreactions to earnings, and are not clearly linked to the stock price overreactions discussed in DeBondt and Thaler ( 1985 , 1987 ) and Chopra, Lakonishok, and Ritter (Forthcoming). We conclude that security analysts' behavior is at best only a partial explanation for stock price underreaction to earnings, and may be unrelated to stock price overreactions.