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Evidence presented here is consistent with a failure of stock prices to reflect fully the implications of current earnings for future earnings. Specifically, the three-day price reactions to announcements of earnings for quarters t + 1 through I + 4 are predictable, based on earnings of quarter r. Even more surprisingly, the signs and magnitudes of the three-day reactions are related to the autocorrelation structure of earnings, as if stock prices fail to reflect the extent to which each firm's earnings series differs from a seasonal random walk.

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-earningsannouncement 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.The Journal of Finance action to earnings, and suggest that corrections of such overreactions may explain the long-term reversals of extreme prior stock price changes documented by DeBondt and Thaler (1985) and Chopra, Lakonishok, and Ritter (Forthcoming).The literature on both underreaction and overreaction includes some evidence to indicate that the anomalous stock price behavior around earnings announcements may be rooted in a failure by market participants to appreciate what current earnings imply about future earnings. Among such studies, Brennan (1991, p. 70) states that "perhaps the most severe challenge to financial theorists ... [includes] the finding by Bernard and Thomas (1989Thomas ( , 1990)" that stock returns around earnings announcements can be characterized by a model in which stock prices partially reflect a naive seasonal random walk earnings expectation. That is, stock prices appear to reflect expectations of quarterly earnings that are anchored too heavily on the earnings of the corresponding quarter of the prior year, and that underreact to more recent earnings news. Consistent with this possibility, Mendenhall (1991) documents that one important group of stock market participants, Value Line analysts, appears to underreact to the most recent quarterly earnings observation when producing their forecasts.1In apparent contrast to the literature that indicates underreaction to earnings, DeBondt and Thaler (1987) describe how investor "myopia" could lead to an overemphasis on earnings from the recent past, and DeBondt and Thaler (1990) report evidence to suggest that analysts' earnings forecasts tracked by Institutional Brokers Estimate System (IBES) are indeed "consistent with generalized overreaction." Specifically, they show that earnings changes forecasted by analysts are significantly more extreme than actual realizations, and conclude that the forecasts "are simply too extreme to be considered rational....

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