Disagreement, Short Sale Constraints, and Speculative Trading Before Earnings Announcements

Abstract

Consistent with theoretical models of speculative trading, we show that abnormal trading activity increases before earnings announcements, especially for stocks with high dispersion of opinions. Moreover, consistent with Miller's (1977) theory and other disagreement models, for stocks that are also short sale constrained this increased speculative pressure is dominated by buyer-initiated trading. As a result, stocks that are already prone to Miller's overpricing (with high dispersion of opinions and binding short sale constraints) have a further price increase before earnings announcements. Finally, these same stocks have a predictable price reversal after the announcement that dominates the pre-announcement run-up, and is related to the abnormal trading activity before the announcement.

Keywords: market efficiency, speculation, disagreement, dispersion of opinions, limits to arbitrage, institutional ownership, short sale restrictions, overpricing, earnings announcements

JEL Classification: D82, G14, G19