Buy on the Rumor: Disagreement, Short Sale Constraints, and Speculative Trading Before Earnings Announcements

We show that abnormal trading activity increases in the days before earnings announcements, especially for stocks with high dispersion of opinions. Consistent with the theory of Miller (1977) and other disagreement models, for stocks that are also short sale constrained, this increased speculative trading is dominated by net buyer-initiated trading activity. This evidence helps to explain why stocks that are already prone to Miller’s overpricing (i.e., with high dispersion of opinions and binding short sale constraints) have a further price increase before earnings announcements. Also consistent with disagreement models, we show that such overpriced stocks have a predictable price reversal after the announcement whose magnitude is related to the extent of abnormal trading activity before the announcement. JEL Classification: D82, G14, G19.