Streaks in Earnings Surprises and the Cross-Section of Stock Returns

The gambler's fallacy [Rabin, M. 2002. Inference by believers in the law of small numbers. <i>Quart. J. Econom.</i> <b>117</b>(3) 775-816] predicts that trends bias investor expectations. Consistent with this prediction, we find that investors underreact to streaks of consecutive earnings surprises with the same sign. When the most recent earnings surprise extends a streak, post-earnings-announcement drift is strong and significant. In contrast, the drift is negligible following the termination of a streak. Indeed, streaks explain about half of the post-earnings-announcement drift in our sample. Our results are robust to more general definitions of trends than streaks and a battery of control variables including the magnitude of earnings surprises and their autocorrelation. Overall, post-earnings-announcement drift has a significant time-series component that is consistent with the gambler's fallacy. <i>This paper was accepted by Wei Xiong, finance.</i>