The key to finding an edge | stockbee

10/16/2006

The key to finding an edge

The key to finding an edge is to find market anomalies. Markets are not random. For many years studies after studies have shown two anomalies which make profits

1 PEAD- Post Earning Announcement drift
2 Momentum effect


PEAD- Post Earning Announcement Drift
Each quarter when companies report their earnings, there are usually a handful of companies whose earnings are either surprisingly good, or shockingly bad. You can immediately recognize these companies by the post earnings announcement jump or plunge in their respective stock prices. So far so good. But now fast forward, say, three quarters. If you take a look at all the stocks that had negative earnings surprises, you find that on average these stocks continued to go down. Similarly, the stocks that had positive earnings surprises continued to go up, on average. In other words, the stocks with earnings surprises exhibit post earnings announcement drift, or PEAD for short. Now this is weird. Every finance professor will tell you that this isn't suppose to happen. If the stock market is efficient, what should happen is a one-time jump in the stock price when earnings are announced.

This PEAD effect was first identified in a paper published in 1968, almost 40 years ago. Generally, when research on market inefficiencies is published, people start trading against the inefficiency and the anomaly goes away. But not with PEAD. Subsequent papers have overwhelmingly found the same result. PEAD is considered one of the most robust stock market anomalies around. And, so far, nobody really knows why....


Momentum effect
There is substantial evidence that indicates that stocks that perform the best (worst) over a three to 12 month period tend to continue to perform well (poorly) over the subsequent three to 12 months. Momentum trading strategies that exploit this phenomenon have been consistently profitable in the United States and in most developed markets. Similarly, stocks with high earnings momentum outperform stocks with low earnings momentum.



Hundreds of studies have shown this behavior continues in the market years after year. Like this there are many anomalies and if you find them you will not have to worry about making money and losing your edge. I basically trade 5-6 such anomalies. Each one of them have a statistically proven edge and logic as to why they work.

Many of these things are in public domain for years. Why people don't trade them, because most people are lost in technical analysis jungle. Secondly many people trade on too short a time frame to capture returns from such strategies. Some of the most profitable systems are based on finding such anomalies.

7 comments:

market operator said...

New reader here, I was curious where and how you identify new academic research. I have used the SSRN Electronic Library but haven't found a lot of useful info.
Thanks!

Pradeep Bonde said...

There are books written by Academics on market. Which as expected do not sell well on Amazon as compared to books on technical analysis.
Some of the authors I can think off as of now are:
Benoit Mandelbrot
Aswath Damodaran
Robert A. Haugen
Bruce I. Jacobs,
Kenneth N. Levy,
Harry M. Markowitz
You will find lot of cross reference to these kind of studdies in them. Knowing people in Universities, PhD students doing PhD in finance also helps.
There are many such anomalies in the markets which offer enduring edges.

Pradeep Bonde said...

Beyond the Random Walk: A Guide to Stock Market Anomalies and Low-Risk Investing by Vijay Singal has description of some well known anomalies.

market operator said...

Thanks! I'll check those out, have you come across any interesting anomalies or resources for shorter duration trades, i.e. a few days or weeks time frame.

Pradeep Bonde said...

James Altucher book has many.

My focus is long term, not interested in 1 to 5% kind of edges.

Art said...

TGIS on 2FEb had great earnings but went down bigtime. What did I miss on your great tutorial this morning please? Does this double-bottom suggest we now have a better buy on a good stock. Or did the market see something to avoid which will make this a stock which PEAD suggests will see many down qtrs to come?

thank you

Pradeep Bonde said...

Options backdating scandal, if I remember correctly.