Naïve Earnings Growth Extrapolation

Abstract

Exploiting the unique financial reporting format in China, we document that stocks with the strongest past year-to-date earnings growth experience a significant price run-up of 1.2% during the five trading days before their quarterly earnings announcements and a significant return reversal of -1.35% in the five trading days afterward. This inverted V-shaped pattern on cumulative return spreads is more pronounced among smaller firms with lower institutional ownership and fewer analyst coverage, and it is less pronounced among foreign B-share. Consistent with investor excess demand driving the price run-up, we find retail investor sentiment and buy-sell order imbalance rise ahead of earnings announcements for firms with high past earnings growth. Our findings support models of fundamental extrapolation and suggest investors naively extrapolate the salient but not-so-informative year-to-date earnings growth when forming expectations about the upcoming earnings.