Returns Momentum, Returns Reversals and Earnings Surprises

Abnormal stock returns measured over intervals of less than a year exhibit positive serial correlation, or returns momentum, while returns measured over longer periods exhibit negative serial correlation, or returns reversals. This paper examines if patterns in earnings surprises, together with investors? inefficient reactions to those earnings surprises, account for the observed serial correlation in returns. Prior literature has documented that over periods of less than one year, earnings surprises are positively serially correlated. We document that over longer periods, they are negatively serially correlated. This pattern is strikingly similar to the pattern in returns. In addition to documenting these patterns across intervals, we also show that for any particular interval, the serial correlation of returns and the serial correlation of earnings surprises are related. Controlling for cross-sectional differences in firms? serial correlations in earnings surprises, we are able to eliminate the serial correlation in returns at 3-, 24-, 36-, and 48-month intervals. We find some evidence of residual serial correlation in returns at 6-, 12-, and 60-month intervals. Overall, our results suggest that the serial correlation in earnings surprises is an important factor in determining the sign and magnitude of the serial correlation in returns.