Changling Chen
University of Wisconsin–Madison
Abstract: The purpose of this research is to investigate whether the market prices firms with increasing trends in past earnings efficiently in the sense that it properly reflects the persistence of these trends. I demonstrate that past increasing earnings trends with small but stable earnings innovations are more likely to persist into the future relative to past increasing earnings trends with large but volatile earnings innovations. The market underreacts to persistent increasing trends in past earnings and overreacts to non-persistent increasing trends in past earnings. As a result, increasing trends in past earnings with small stable earnings innovations can predict positive future abnormal returns, and conversely, increasing trends in past earnings with large volatile earnings innovations can predict negative future abnormal returns. The results are robust after controlling for earnings-price ratio, book-to-market ratio, size effects, and alternative measures of abnormal returns (market-adjusted and size-adjusted excess returns).
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