N.Barberis et al./Journal of Financial Economics 49 (1998)307-343 311 return in the period following bad news: E(r+2=G)>E(r+=B). In other words,the stock underreacts to the good news,a mistake which is corrected in the following period,giving a higher return at that time.In this paper,the good news consists of an earnings announcement that is higher than expected,although as we discuss below,there is considerable evidence of underreaction to other types of news as well. Empirical analysis of aggregate time series has produced some evidence of underreaction.Cutler et al.(1991)examine autocorrelations in excess returns on various indexes over different horizons.They look at returns on stocks,bonds, and foreign exchange in different markets over the period 1960-1988 and generally,though not uniformly,find positive autocorrelations in excess index returns over horizons of between one month and one year.For example,the average one-month autocorrelation in excess stock returns across the world is around 0.1 (and is also around 0.1 in the United States alone),and that in excess bond returns is around 0.2(and around zero in the United States).Many of these autocorrelations are statistically significant.This autocorrelation evidence is consistent with the underreaction hypothesis,which states that stock prices incorporate information slowly,leading to trends in returns over short horizons. More convincing support for the underreaction hypothesis comes from the studies of the cross-section of stock returns in the United States,which look at the actual news events as well as the predictability of returns.Bernard(1992) surveys one class of such studies,which deals with the underreaction of stock prices to announcements of company earnings. The finding of these studies is roughly as follows.Suppose we sort stocks into groups (say deciles)based on how much of a surprise is contained in their earnings announcement.One naive way to measure an earnings surprise is to look at standardized unexpected earnings (SUE),defined as the difference between a company's earnings in a given quarter and its earnings during the quarter a year before,scaled by the standard deviation of the company's earnings.Another way to measure an earnings surprise is by the stock price reaction to an earnings announcement.A general (and unsurprising)finding is that stocks with positive earnings surprises also earn relatively high returns in the period prior to the earnings announcement,as information about earnings is incorporated into prices.A much more surprising finding is that stocks with higher earnings surprises also earn higher returns in the period after portfolio formation:the market underreacts to the earnings announcement in revising a company's stock price.For example,over the 60 trading days after portfolio formation,stocks with the highest SUE earn a cumulative risk-adjusted return that is 4.2%higher than the return on stocks with the lowest SUE(see Bernard, 1992).Thus,stale information,namely the SUE or the past earnings announce- ment return,has predictive power for future risk-adjusted returns.Or,putreturn in the period following bad news: E(r t`1 Dz t "G)'E(r t`1 Dz t "B). In other words, the stock underreacts to the good news, a mistake which is corrected in the following period, giving a higher return at that time. In this paper, the good news consists of an earnings announcement that is higher than expected, although as we discuss below, there is considerable evidence of underreaction to other types of news as well. Empirical analysis of aggregate time series has produced some evidence of underreaction. Cutler et al. (1991) examine autocorrelations in excess returns on various indexes over different horizons. They look at returns on stocks, bonds, and foreign exchange in different markets over the period 1960—1988 and generally, though not uniformly, find positive autocorrelations in excess index returns over horizons of between one month and one year. For example, the average one-month autocorrelation in excess stock returns across the world is around 0.1 (and is also around 0.1 in the United States alone), and that in excess bond returns is around 0.2 (and around zero in the United States). Many of these autocorrelations are statistically significant. This autocorrelation evidence is consistent with the underreaction hypothesis, which states that stock prices incorporate information slowly, leading to trends in returns over short horizons. More convincing support for the underreaction hypothesis comes from the studies of the cross-section of stock returns in the United States, which look at the actual news events as well as the predictability of returns. Bernard (1992) surveys one class of such studies, which deals with the underreaction of stock prices to announcements of company earnings. The finding of these studies is roughly as follows. Suppose we sort stocks into groups (say deciles) based on how much of a surprise is contained in their earnings announcement. One naive way to measure an earnings surprise is to look at standardized unexpected earnings (SUE), defined as the difference between a company’s earnings in a given quarter and its earnings during the quarter a year before, scaled by the standard deviation of the company’s earnings. Another way to measure an earnings surprise is by the stock price reaction to an earnings announcement. A general (and unsurprising) finding is that stocks with positive earnings surprises also earn relatively high returns in the period prior to the earnings announcement, as information about earnings is incorporated into prices. A much more surprising finding is that stocks with higher earnings surprises also earn higher returns in the period after portfolio formation: the market underreacts to the earnings announcement in revising a company’s stock price. For example, over the 60 trading days after portfolio formation, stocks with the highest SUE earn a cumulative risk-adjusted return that is 4.2% higher than the return on stocks with the lowest SUE (see Bernard, 1992). Thus, stale information, namely the SUE or the past earnings announce￾ment return, has predictive power for future risk-adjusted returns. Or, put N. Barberis et al./Journal of Financial Economics 49 (1998) 307—343 311