312 N.Barberis et al./Journal of Financial Economics 49 (1998)307-343 differently,information about earnings is only slowly incorporated into stock prices. Bernard also summarizes some evidence on the actual properties of the time series of earnings,and provides an interpretation for his findings.The relevant series is changes in a company's earnings in a given quarter relative to the same calendar quarter in the previous year.Over the period 1974-1986,using a sample of 2626 firms,Bernard and Thomas(1990)find that these series exhibit an autocorrelation of about 0.34 at a lag of one quarter,0.19 at two quarters, 0.06 at three quarters,and -0.24 at four quarters.That is,earnings changes exhibit a slight trend at one-,two-,and three-quarter horizons and a slight reversal after a year.In interpreting the evidence,Bernard conjectures that market participants do not recognize the positive autocorrelations in earnings changes,and in fact believe that earnings follow a random walk.This belief causes them to underreact to earnings announcements.Our model in Section 3 uses a related idea for generating underreaction:we suppose that earnings follow a random walk but that investors typically assume that earnings are mean- reverting.The key idea that generates underreaction,which Bernard's and our analyses share,is that investors typically (but not always)believe that earnings are more stationary than they really are.As we show below,this idea has firm foundations in psychology. Further evidence of underreaction comes from Jegadeesh and Titman(1993), who examine a cross-section of U.S.stock returns and find reliable evidence that over a six-month horizon,stock returns are positively autocorrelated.Similarly to the earnings drift evidence,they interpret their finding of the 'momentum'in stock returns as pointing to underreaction to information and slow incorpora- tion of information into prices.?More recent work by Rouwenhorst(1997) documents the presence of momentum in international equity markets.Chan et al.(1997)integrate the earnings drift evidence with the momentum evidence They use three measures of earnings surprise:SUE,stock price reaction to the earnings announcement,and changes in analysts'forecasts of earnings.The authors find that all these measures,as well as the past return,help predict subsequent stock returns at horizons of six months and one year.That is,stocks with a positive earnings surprise,as well as stocks with high past returns,tend to subsequently outperform stocks with a negative earnings surprise and poor returns.Like the other authors,Chan,Jegadeesh,and Lakonishok conclude that investors underreact to news and incorporate information into prices slowly. In addition to the evidence of stock price underreaction to earnings announcements and the related evidence of momentum in stock prices,there is also a body of closely related evidence on stock price drift following many other announcements and events.For example,Ikenberry et al.(1995)find that stock 7Early evidence on momentum is also contained in De Bondt and Thaler(1985).7Early evidence on momentum is also contained in De Bondt and Thaler (1985). differently, information about earnings is only slowly incorporated into stock prices. Bernard also summarizes some evidence on the actual properties of the time series of earnings, and provides an interpretation for his findings. The relevant series is changes in a company’s earnings in a given quarter relative to the same calendar quarter in the previous year. Over the period 1974—1986, using a sample of 2626 firms, Bernard and Thomas (1990) find that these series exhibit an autocorrelation of about 0.34 at a lag of one quarter, 0.19 at two quarters, 0.06 at three quarters, and !0.24 at four quarters. That is, earnings changes exhibit a slight trend at one-, two-, and three-quarter horizons and a slight reversal after a year. In interpreting the evidence, Bernard conjectures that market participants do not recognize the positive autocorrelations in earnings changes, and in fact believe that earnings follow a random walk. This belief causes them to underreact to earnings announcements. Our model in Section 3 uses a related idea for generating underreaction: we suppose that earnings follow a random walk but that investors typically assume that earnings are mean￾reverting. The key idea that generates underreaction, which Bernard’s and our analyses share, is that investors typically (but not always) believe that earnings are more stationary than they really are. As we show below, this idea has firm foundations in psychology. Further evidence of underreaction comes from Jegadeesh and Titman (1993), who examine a cross-section of U.S. stock returns and find reliable evidence that over a six-month horizon, stock returns are positively autocorrelated. Similarly to the earnings drift evidence, they interpret their finding of the ‘momentum’ in stock returns as pointing to underreaction to information and slow incorpora￾tion of information into prices.7 More recent work by Rouwenhorst (1997) documents the presence of momentum in international equity markets. Chan et al. (1997) integrate the earnings drift evidence with the momentum evidence. They use three measures of earnings surprise: SUE, stock price reaction to the earnings announcement, and changes in analysts’ forecasts of earnings. The authors find that all these measures, as well as the past return, help predict subsequent stock returns at horizons of six months and one year. That is, stocks with a positive earnings surprise, as well as stocks with high past returns, tend to subsequently outperform stocks with a negative earnings surprise and poor returns. Like the other authors, Chan, Jegadeesh, and Lakonishok conclude that investors underreact to news and incorporate information into prices slowly. In addition to the evidence of stock price underreaction to earnings announcements and the related evidence of momentum in stock prices, there is also a body of closely related evidence on stock price drift following many other announcements and events. For example, Ikenberry et al. (1995) find that stock 312 N. Barberis et al./Journal of Financial Economics 49 (1998) 307—343