An important question is whether our full model, and not just regime 1, is
consistent with all of the event study evidence. Michaely et al. (1995) find
that stock prices of dividend-cutting firms decline on the announcement of
the cut but then continue falling for some time afterwards. This finding is
consistent with our regime 1 in that it involves underreaction to the new and
useful information contained in the cut. But we also know that dividend
cuts generally occur after a string of bad earnings news. Hence, if a long
string of bad earnings news pushes investors towards believing in regime 2,
another piece of bad news such as a dividend cut would perhaps cause an
overreaction rather than an underreaction in our model.^12
While this certainly is one interpretation of our model, an alternative
way of thinking about dividend announcements is consistent with both our
model and the evidence. Specifically, our model only predicts an overreac-
tion when the new information is part of a long string of similar numbers,
such as earnings or sales figures. An isolated information event such as a
dividend cut, an insider sale of stock, or a primary stock issue by the firm
does not constitute part of the string, even though it could superficially be
classified as good news or bad news like the earnings numbers that pre-
ceded it. Investors need not simply classify all information events, whatever
their nature, as either good or bad news and then claim to see a trend on
this basis. Instead, they may form forecasts of earnings or sales using the time
series for those variables and extrapolate past trends too far into the future.
Under this interpretation, our model is consistent with an overreaction to a
long string of bad earnings news and the underweighting of informative
bad news of a different type which arrives shortly afterwards.
A related empirical finding is that even for extreme growth stocks that
have had several consecutive years of positive earnings news, there is un-
derreaction to quarterly earnings surprises. Our model cannot account for
this evidence since it would predict overreaction in this case. To explain this
evidence, our model needs to be extended. One possible way to extend the
model is to allow investors to estimate the level and the growth rate of
earnings separately. Indeed, in reality, investors might use annual earnings
numbers over five to seven years to estimate the growth rate but higher fre-
quency quarterly earnings announcements (perhaps combined with other
information) to estimate earnings levels. Suppose, for example, that earn-
ings have been growing rapidly over five years, so that an investor using the
representativeness heuristic makes an overly optimistic forecast of the fu-
ture growth rate. Suppose then that a very positive earnings number is an-
nounced. Holding the estimated long-run growth rate of earnings constant,
A MODEL OF INVESTOR SENTIMENT 447(^12) Another study that presents a similar puzzle is by Ikenberry et al. (1996). They find that
the positive price reaction to the announcement of a stock split is followed by a substantial
drift in the same direction over the next few years. However, the split is also often preceded by
a persistent run-up in the stock price, suggesting an overreaction that should ultimately be re-
versed.