Do Stock Prices Overreact

to Earnings News?
Bhaskaran Swaminathan and Charles Lee

Presentation by

Bhaskaran Swaminathan, Cornell University

May 16, 2000

Department of Finance
Kellstadt Graduate School of Business
DePaul University
Introduction
Momentum and Reversals
Motivation: Reconciling Momentum and
Reversals
Papers objectives
Key Findings
Sample & Methodology
Results
Conclusions
 Momentum and Reversals
Reversals at short-horizons (1 month or 1 week)
Jegadeesh (1990), Lehman (1990).

Momentum at intermediate horizons (3 to 12 months)

Price Momentum: Jegadeesh and Titman (1993);
Earnings Momentum: Foster, Olsen, and Shevlin (1984),
Bernard and Thomas (1990);
Interaction: Chan, Jegadeesh, Lakonishok (1996).
Evidence of underreaction (?).

Reversals at long-horizons (3-5 yrs)

Past Returns: De Bondt and Thaler (1985, 1987); P/B, P/E,
P/C: Fama-French (1992), LSV (1994); P/V: Frankel and Lee
(1998) and Lee, Myers, and Swaminathan (1998).
Evidence of overreaction.
Motivation: Reconciling Momentum and
Reversals
Are momentum and reversals related?
Behavioral models suggest initial momentum turns into
subsequent reversals.
Barberis, Shleifer, and Vishny (1998), Daniel,
Hirshleifer, and Subrahmanyam (1998), Hong and
Stein (1999).
Lee and Swaminathan (1999) and Jegadeesh and
Titman (1999) present empirical evidence:
Price momentum reverses over the next five years.
Intermediate-term winners (losers) become long-term
losers (winners).
Price reaction to quarterly earnings news?
 Papers objectives
Does the initial momentum in response to quarterly
earnings news (post-earnings announcement drift)
reverse in the long-run?
Earnings news are pure fundamental signals; price
momentum is a noisy proxy for fundamental news.
Price momentum reversals need not necessarily imply
reversals of post-earnings announcement drift (HS (1999)).

How does a sequence of earnings news affect

momentum and reversals (BSV (1998))?.
More generally, how do stock prices respond to current
earnings news conditional on past news (past earnings
news and returns)?
 Key Findings
Post-earnings announcement drift reverses in the long-run,
especially for stocks with longer earnings momentum.
Specifically, the reversals are stronger (weaker) if current
earnings news confirms (contradicts) past earnings news;
More generally, overvalued winners and undervalued losers
exhibit return reversals while undervalued winners and
overvalued losers exhibit momentum.
Momentum and reversals are related to investor
misperceptions about future earnings.
Overall, evidence suggests prices underreact to recent good
or bad news, but overreact to long-term good or bad news.
Consistent with Barberis, Shleifer, and Vishny (1999) and
Bloomfield, Libby, and Nelson (1999).
Sample and Methodology
Stocks in CRSP - NYSE/AMEX stocks and
COMPUSTAT excluding closed-end funds, REITs,
ADRS from1974 to 1995.
Require two years of NYSE/AMEX data and five
years of quarterly earnings data on COMPUSTAT
as of the portfolio formation date.
Quarterly earnings surprises - standardized
unexpected earnings (SUE) - based on a quarterly
seasonal random walk model of earnings.
J-quarter earnings momentum is computed as the
arithmetic average of decile SUE ranks over the
past J quarters.
Methodology - Computing Earnings
Surprises
Seasonal random walk with drift for computing
expected quarterly earnings:
E (eiq ) i ei,q4

SUE of stock i as of the beginning of month t for

the qth quarter prior to month t:
eitq eitq4 itq
SUEitq
itq

itq and itq are respectively the mean and the

standard deviation of earnings changes over the
eight quarters prior to quarter q as of month t .
Methodology - Defining Earnings
Momentum
Compute decile ranks for all stocks available at the
beginning of month t based on the qth quarters
SUE prior to month t (q=1,2,..,8).
J-quarter earnings momentum is defined as the
equal-weighted average of the past J quarters
(J=1,2,3,4,6) decile SUE ranks Ritq:

J Ritq
EM it ( J )
q 1 J
Forming Earnings Momentum Portfolios

Past J Quarters Future K Months

Month t
1 Week Gap

At the beginning of every month, assign stocks to one of ten

(or five) portfolios based on past earnings momentum [E10 (or
E5) is the winner and E1 is the loser] J=1,2,3,4,6. Compute
portfolio returns over the next 5 years.
In bivariate strategies, the stocks are also independently
sorted on past earnings momentum, trading volume, or B/M
ratios into 3 or 5 portfolios.
 Subsequent returns
The portfolios are held for K=1, 3, 6, 9, 12 months. The ex
post returns can be computed as the arithmetic average
monthly return over the holding period.
We use the strategy suggested by Jegadeesh and Titman (1993)
to compute returns. Specifically, monthly returns for the K-
month holding period is the weighted average of returns from
strategies initiated in the current and the past K-1 months.
This strategy revises the weights on 1/K of the securities in the
portfolio every month.
We also compute event-time annual returns for the next five
years.
 Univariate Earnings Momentum (Table 1)
J Port. SUE B/M Return Volume SzRnk Monthly Returns Annual Event Time Returns
K=1 K=3 K=6 K=9 K=12 Year 1 Year 2 Year 3 Year 4
1 E1 -4.30 0.89 -0.98 0.1678 5.49 -0.88 -0.71 -0.58 -0.45 -0.32 -5.29 -2.11 -1.42 0.69
(-12.46) (-10.65) ( -8.86) ( -7.21) ( -5.48) ( -9.52) ( -3.54) ( -1.62) ( 0.88)
E10 3.05 0.73 2.76 0.1625 6.08 0.76 0.52 0.37 0.22 0.12 2.20 -0.47 -0.31 -1.11
( 10.38) ( 7.53) ( 5.60) ( 3.62) ( 2.16) ( 2.58) ( -0.80) ( -0.58) ( -1.74)
E10-E1 1.64 1.23 0.95 0.67 0.44 7.49 1.65 1.10 -1.81
( 13.26) ( 10.42) ( 8.10) ( 6.05) ( 4.31) ( 6.17) ( 1.62) ( 0.85) ( -1.38)

3 E1 -2.26 0.91 -1.05 0.1721 5.44 -0.68 -0.57 -0.45 -0.35 -0.28 -4.67 -2.35 -1.31 1.93
( -8.49) ( -7.57) ( -6.00) ( -4.54) ( -3.78) ( -6.96) ( -2.21) ( -1.04) ( 1.94)
E10 1.86 0.66 2.60 0.1747 6.34 0.54 0.43 0.24 0.12 0.08 1.14 0.30 -0.48 -1.49
( 5.64) ( 4.52) ( 2.64) ( 1.39) ( 0.97) ( 1.00) ( 0.31) ( -0.62) ( -1.64)
E10-E1 1.22 1.00 0.69 0.47 0.36 5.82 2.65 0.83 -3.42
( 7.97) ( 6.69) ( 4.64) ( 3.21) ( 2.61) ( 3.60) ( 1.56) ( 0.47) ( -2.14)

6 E1 -1.81 0.95 -0.74 0.1683 5.41 -0.46 -0.42 -0.35 -0.29 -0.25 -3.94 -2.63 0.69 2.15
( -5.00) ( -4.68) ( -4.01) ( -3.35) ( -3.10) ( -4.35) ( -2.31) ( 0.47) ( 2.35)
E10 1.43 0.61 2.34 0.1837 6.62 0.32 0.22 0.15 0.07 0.04 0.78 0.00 -1.43 -1.72
( 3.05) ( 2.21) ( 1.56) ( 0.85) ( 0.50) ( 0.65) ( 0.00) ( -1.65) ( -1.80)
E10-E1 0.78 0.64 0.50 0.36 0.29 4.72 2.63 -2.12 -3.87
( 4.53) ( 3.84) ( 3.12) ( 2.37) ( 2.05) ( 2.45) ( 1.42) ( -1.04) ( -2.84)

Earnings momentum reverses in Year 4, especially longer the past

earnings momentum.
Winners reverse faster than losers.
Univariate Earnings Momentum (Table 2)

Consecutive winners and losers.

Stocks in the top (bottom) 1/3rd of SUE winners for 2
or more quarters are termed consecutive winners
(losers).
Table 2 presents returns from earnings momentum
strategies based on consecutive winners and losers.
Provides an unambiguous test of the hypothesis that
stock prices tend to overreact to a series of good or
bad news.
 Table 2 Consecutive Winners and Losers
J Port. SUE B/M Return Volume SzRnk Monthly Returns Annual Event Time Returns
K=1 K=3 K=6 K=9 K=12 Year 1 Year 2 Year 3 Year 4 Year 5
1 E1 -1.99 0.88 -0.19 0.1522 5.53 -0.57 -0.44 -0.31 -0.22 -0.15 -2.54 -0.97 -0.45 0.60 0.38
(-13.54) (-10.95) ( -8.13) ( -6.07) ( -4.34) ( -6.02) ( -2.20) ( -0.86) ( 1.18) ( 0.88)
E3 1.61 0.77 2.22 0.1550 5.90 0.52 0.39 0.27 0.17 0.10 1.84 0.28 0.15 -0.85 -0.37
( 12.36) ( 9.71) ( 7.09) ( 4.73) ( 2.98) ( 3.84) ( 0.67) ( 0.33) ( -1.64) ( -0.82)
E3-E1 1.09 0.82 0.58 0.40 0.25 4.37 1.25 0.59 -1.45 -0.75
( 13.60) ( 10.75) ( 7.86) ( 5.57) ( 3.77) ( 5.10) ( 1.50) ( 0.63) ( -1.44) ( -0.88)

3 E1 -1.98 0.90 -1.02 0.1731 5.42 -0.58 -0.47 -0.35 -0.21 -0.21 -3.74 -1.84 -0.86 1.93 0.23
( -7.56) ( -6.40) ( -4.84) ( -2.94) ( -2.94) ( -6.24) ( -1.83) ( -0.74) ( 2.01) ( 0.27)
E3 1.71 0.63 2.63 0.1850 6.22 0.49 0.40 0.23 0.08 0.08 1.20 0.42 -0.21 -1.03 -0.27
( 5.38) ( 4.53) ( 2.74) ( 1.10) ( 1.10) ( 1.15) ( 0.47) ( -0.27) ( -1.08) ( -0.21)
E3-E1 1.06 0.86 0.58 0.29 0.29 4.94 2.26 0.65 -2.96 -0.49
( 7.25) ( 6.11) ( 4.17) ( 2.27) ( 2.27) ( 3.36) ( 1.40) ( 0.39) ( -1.81) ( -0.26)

6 E1 -1.96 0.95 -1.10 0.1742 5.56 -0.69 -0.59 -0.58 -0.49 -0.41 -5.95 -2.56 1.52 2.57 1.46
( -3.77) ( -3.34) ( -3.41) ( -3.04) ( -2.70) ( -3.97) ( -0.93) ( 0.66) ( 2.12) ( 0.90)
E3 1.73 0.49 2.70 0.2146 7.21 0.29 0.16 0.07 -0.05 -0.12 -1.62 -2.94 -2.43 -3.02 -0.15
( 1.61) ( 0.91) ( 0.44) ( -0.30) ( -0.88) ( -0.77) ( -1.33) ( -1.61) ( -1.56) ( -0.05)
E3-E1 0.98 0.75 0.65 0.45 0.29 4.33 -0.39 -3.94 -5.59 -1.60
( 3.37) ( 2.69) ( 2.45) ( 1.78) ( 1.23) ( 1.38) ( -0.09) ( -1.47) ( -3.03) ( -0.46)

Consecutive winners and losers exhibit even stronger reversals.

Consecutive winners exhibit stronger reversals than consecutive
losers.
Regression tests of momentum and
reversals Table 3
J
rt K ,i aK bK SUEtiq / J cK LnSZEit ut K ,i
q 1

rt+K represents return the Kth years stock return.

Monthly Fama-MacBeth cross-sectional regressions.
Time-series average of monthly slope coefficients.
Overlapping monthly observations requires Hansen-
Hodrick autocorrelation correction with eleven lags.
bK represents the predictive power of average SUEs.
LnSZE is a control for firm size.
Table 3: Regression Tests
Time-series Average Slope Coefficients, bK
K J=1 J=2 J=3 J=4
1 0.0086 0.0103 0.0105 0.0109
(5.88) (4.45) (3.90) (3.54)

2 0.0024 0.0041 0.0049 0.0056

(2.11) (2.10) (1.84) (1.71)

3 0.0012 0.0018 0.0012 -0.0007

(0.78) (0.82) (0.45) (-0.19)

4 -0.0034 -0.0041 -0.0048 -0.0057

(-1.94) (-1.87) (-2.00) (-2.37)

5 -0.0014 -0.0018 -0.0018 -0.0015

(-1.16) (-0.86) (-0.61) (-0.40)

bK is positive and significant in Years 1 and 2 signifying momentum.

bK is negative and significant in Year 4 signifying reversals.
Significant at 1% or 5% level based on one-sided tests.
Price response to current news conditional
on past news
Agents may under-weigh current news and over-
weight old news (see Griffin and Tversky (1992),
BSV (1999), Bloomfield, Libby and Nelson (1999)).
Stocks where recent news confirms past news are
likely to overreact. Because investors tend to
extrapolate past too far into the future.
Stocks where recent news contradicts past news are
likely to underreact. Because, investors are slow to
revise their expectations in light of disconfirming
news.
Price response to current news conditional on past
news
For value winners and glamour losers, recent news contradicts past news;
they are expected to underreact and exhibit momentum.
For glamour winners and value losers, recent news confirms past news;
they are expected to overreact and exhibit reversals.
Whether prices underreact or overreact to recent news depends on the
sequence of past news. This is captured by the momentum life cycle.
 Table 4: Conditional on Past Performance
Panel A: Earnings Momentum-Trading Volume Portfolios
J Portfolio V1 V3
Year 1 Year 2 Year 3 Year 4 Year 5 Year 1 Year 2 Year 3 Year 4 Year 5
1 E1 -2.52 -0.84 -0.26 0.39 0.12 -7.60 -3.19 -2.93 0.03 1.30
(-1.95) (-0.71) (-0.22) ( 0.34) ( 0.08) (-7.47) (-2.40) (-1.97) ( 0.02) ( 1.05)
E10 5.06 0.84 -0.60 -0.66 0.17 0.97 -2.42 -0.94 -2.82 -0.54
( 6.68) ( 0.91) (-0.45) (-0.43) ( 0.15) ( 0.55) (-1.65) (-0.78) (-2.34) (-0.31)
Panel B: Earnings Momentum-B/M Portfolios
J Portfolio bm1 bm5
1 E1 -8.57 -4.97 -3.52 -2.92 -3.52 -2.31 -0.26 1.08 4.12 0.88
( -5.24) ( -3.95) ( -2.32) ( -1.50) ( -2.54) ( -1.71) ( -0.21) ( 0.82) ( 3.19) ( 0.60)
E5 -0.64 -3.48 -2.73 -3.10 -2.32 4.97 1.83 4.21 1.81 1.37
( -0.33) ( -2.02) ( -2.24) ( -3.00) ( -1.23) ( 3.08) ( 1.61) ( 2.77) ( 1.38) ( 1.51)
Panel C: Current SUE and Past Earnings Momentum Portfolios
J Portfolio ps1 ps3
1 E1 -4.96 -2.72 -0.81 3.37 0.74 -7.01 -1.08 -0.29 -0.87 3.30
( -6.03) ( -2.10) ( -0.44) ( 2.63) ( 0.74) ( -4.26) ( -0.65) ( -0.18) ( -0.34) ( 1.62)
E5 2.78 1.25 2.05 -1.84 -0.77 0.67 0.04 -0.69 -2.31 -0.79
( 1.80) ( 0.57) ( 1.45) ( -0.71) ( -0.50) ( 0.43) ( 0.03) ( -0.64) ( -2.38) ( -0.46)

Glamour winners (E10V3, E5bm1, E5ps3) and value losers (E1V1,

E1bm3, E1ps1) exhibit reversals;
Value winners (E10V1, E5bm3, E5ps1) and glamour losers (E1V3,
E1bm1, E1ps3) exhibit return continuations.
Early-Stage and Late-Stage Strategies
Momentum strategies executed early in the cycle
should earn higher returns than those executed
late in the cycle.
Buy early-stage (value) winners & sell early-stage
(glamour) losers.
This strategy should outperform the simple earnings
momentum strategy and exhibit return continuation.
Buy late-stage (glamour) winners & sell late-stage
(value) losers.
This strategy should underperform the simple earnings
momentum strategy and exhibit return reversals.
Table 5 supports these predictions.
Regressions in Table 6 confirm Table 5 findings.
 Table 5: Early/Late Strategies
Panel A: Earnings Momentum and Trading Volume
Strategy Year 1 Year 2 Year 3 Year 4 Year 5
E10-E1 (Simple) 7.49 1.65 1.10 -1.81 -0.66
( 6.17) ( 1.62) ( 0.85) ( -1.38) ( -0.57)
E10V3-E1V1 (Late) 3.50 -1.58 -0.68 -3.21 -0.67
( 1.24) ( -0.63) ( -0.30) ( -1.71) ( -0.23)
E10V1-E1V3 (Early) 12.66 4.03 2.34 -0.69 -1.13
( 9.09) ( 1.98) ( 0.90) ( -0.24) ( -0.54)
Panel B: Earnings Momentum and B/M Ratios
Strategy Year 1 Year 2 Year 3 Year 4 Year 5
E5-E1 (Simple) 5.66 1.84 0.75 -1.86 -1.02
( 5.17) ( 2.01) ( 0.59) ( -1.45) ( -1.06)
E5bm1-E1bm5 (Late) 1.67 -3.23 -3.81 -7.22 -3.19
( 0.55) ( -1.24) ( -1.78) ( -3.80) ( -1.09)
E5bm5-E1bm1 (Early) 13.54 6.80 7.74 4.73 4.90
( 5.32) ( 3.35) ( 3.16) ( 1.68) ( 2.51)
Panel C: Current Earnings Momentum and Past Earnings Momentum
Strategy Year 1 Year 2 Year 3 Year 4 Year 5
E5-E1 (Simple) 5.57 1.50 0.63 -1.56 -1.20
( 5.15) ( 1.63) ( 0.51) ( -1.24) ( -1.26)
E5ps3-E1ps1 (Late) 5.62 2.77 0.12 -5.68 -1.52
( 2.78) ( 1.40) ( 0.05) ( -3.40) ( -0.67)
E5ps1-E1ps3 (Early) 9.78 2.32 2.34 -0.97 -4.07
( 3.84) ( 0.78) ( 1.06) ( -0.27) ( -1.55)

Early outperforms simple and exhibits longer momentum.

Late underperforms simple and exhibits faster reversals.
Table 6: Regressions Involving Early or
Late Stage Stocks Only
Time-series Average Slope Coefficients, bK
K Volume Based Earnings Momentum Strategies B/M Based Earnings Momentum Strategies
Early Stage, E10V1 & E1V3 Late Stage, E10V3 & E1V1 Early Stage, E5bm5 & E1bm1 Late Stage, E5bm1 & E1bm5
J=1 J= 4 J=1 J=4 J=1 J= 4 J=1 J=4
1 0.0121 0.0157 0.0047 0.0008 0.0230 0.0305 0.0037 0.0048
(8.86) (4.46) (1.36) (0.12) (5.60) (3.64) (0.84) (0.76)

2 0.0031 0.0028 -0.0016 0.0038 0.0119 0.0240 -0.0006 0.0005

(1.53) (0.77) (-0.05) (0.56) (3.82) (3.72) (-0.18) (0.08)

3 -0.0004 -0.0002 0.0003 -0.0062 0.0124 0.0156 -0.0015 -0.0077

(-0.19) (-0.04) (0.10) (-1.04) (3.26) (1.49) (-0.58) (-1.63)

4 -0.0033 -0.0006 -0.0047 -0.0123 0.0061 0.0105 -0.0106 -0.0113

(-1.13) (-0.12) (-2.32) (-3.25) (1.07) (1.26) (-4.37) (-2.40)

5 -0.0024 -0.0003 -0.0007 -0.0037 0.0104 0.0252 -0.0054 -0.0103

(-0.13) (-0.08) (-0.25) (-0.62) (2.35) (4.50) (-1.71) (-1.50)

Early stage stocks exhibit strong momentum and weak reversals.

Late stage stocks exhibit weak momentum and strong reversals.
 Returns Around Quarterly Earnings
Announcements
Are momentum and reversals related to misperceptions
about future earnings?
Tables 7 and 8.
Value winners and losers earn positive returns around future
earnings announcements.
Glamour winners and losers earn negative returns around
future earnings announcements.

Overall, the pattern of abnormal returns around future

earnings releases suggests momentum and reversals
are related to expectations errors about future
earnings.
Earnings Momentum and Price Momentum
All Stocks, Time-series Average Slope Coefficients
K J=1 J=4
S1 r12 LnSZE LnBM LnTOV S4 r12 LnSZE LnBM LnTOV
1 0.0059* 0.0533** ------ ------ ------ 0.0048*** 0.0558* ------ ------ ------
0.0065* 0.0525* -0.0133** ------ ------ 0.0068** 0.0543* -0.0140** ------ ------
0.0068* 0.0708* -0.0071 0.0461* ------ 0.0079* 0.0711* -0.0078 0.0448* ------
0.0064* 0.0716* -0.0043 0.0452* -0.0214** 0.0074** 0.0718* -0.0049 0.0441* -0.0222**

2 0.0015 0.0082 ------ ------ ------ 0.0043*** 0.0065 ------ ------ ------
0.0020** 0.0079 -0.0120*** ------ ------ 0.0057** 0.0052 -0.0128*** ------ ------
0.0021** 0.0249*** -0.0076 0.0361* ------ 0.0065** 0.0202 -0.0083 0.0346* ------
0.0021** 0.0215*** -0.0059 0.0363* -0.0109 0.0065** 0.0165 -0.0066 0.0352* -0.0104

3 0.0008 -0.0014 ------ ------ ------ -0.0050 0.0041 ------ ------ ------
0.0008 0.0032 -0.0129** ------ ------ -0.0029 0.0064 -0.0127** ------ ------
0.0010 0.0204 -0.0094 0.0338* ------ -0.0024 0.0219 -0.0095*** 0.0308* ------
0.0009 0.0168 -0.0091 0.0324* -0.0063 -0.0025 0.0176 -0.0091 0.0230* -0.0070

4 -0.0040** -0.0272*** ------ ------ ------ -0.0075* -0.0263*** ------ ------ ------
-0.0033** -0.0191 -0.0102*** ------ ------ -0.0050** -0.0201 -0.0109*** ------ ------
-0.0034** -0.0058 -0.0078 0.0264* ------ -0.0050** -0.0067 -0.0084 0.0264* ------
-0.0033** -0.0073 -0.0077 0.0251* -0.0021 -0.0050** -0.0088 -0.0083 0.0253** -0.0017

5 -0.0008 -0.0173 ------ ------ ------ -0.0002 -0.0214***

-0.0001 -0.0228** -0.0057 ------ ------ 0.0017 -0.0287** -0.0055 ------- -------
-0.0002 -0.0125 -0.0039 0.0193*** ------ 0.0020 -0.0183 -0.0034 0.0210** -------
-0.0003 -0.0124 -0.0046 0.0172*** 0.0020 0.0017 -0.0186 -0.0042 0.0191** 0.0031

Past earnings momentum predicts future price reversals controlling

for past price momentum, B/M ratios and trading volume.
 Conclusions
Stock prices exhibit initial momentum and subsequent reversals
in response to fundamental earnings news; the reversals are
stronger and happen sooner longer the past earnings
momentum.
Stock prices underreact to recent earnings news and overreact
to a sequence of (longer-term) earnings news.
More generally, value winners and glamour losers underreact
while glamour winners and value losers overreact to news.
The results are broadly consistent with behavioral models that
suggest momentum and reversals are part of the same price
process.
Paints a picture of a stock market in which prices constantly
undershoot and overshoot intrinsic value in responding to public
and private information.