12/17/2007

Pre earnings announcement drift

Pre earnings announcement drift is different from PEAD.
PEAD or Post Earnings Announcement drift anomaly was documented in academic literature for first time in 1968.
The post earnings announcement drift anomaly means the tendency for stocks to earn abnormally high returns in the three quarters following a positive earnings announcement, and to earn abnormally low returns in the three quarters following a negative earnings announcement.
The phenomenon can be explained with a number of hypotheses. The most widely accepted explanation for the effect is investor under-reaction to earnings announcements.
This was initially proposed by the information content study of R. Ball & P. Brown, 'An empirical evaluation of accounting income numbers', Journal of Accounting Research, Autumn 1968, pp. 159-178.
As most of you who have read my blog know, I have been talking about PEAD for long time and the strategies like earnings trading are basically based on this fundamental anomaly. Episodic Pivots (EP) method also uses the same logic to select earnings EP. My original post lays out the PEAD phenomenon clearly.

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.

But stocks also drift up coming in to earnings. You will notice this phenomenon in next 4-6 weeks as we approach the earnings season. Such drift in price coming in to earnings season is called pre earnings drift.

What drives pre earnings drift is either earnings information leakage (which was common pre Reg FD ) or due to analyst actions. Now analyst have a bad reputation on the street, but analysts earnings estimate changes are very powerful thing which often results in pre earnings drift. On companies with extensive analyst coverage, when analyst start raising or decreasing upcoming or future earnings estimate, it results in pre earning drift, if the information is not reflected in the stock price. That is why you will see stocks breaking out 4 to 6 weeks before earnings and then rallying in to earnings season.

There are ways to trade this pre earnings drift for short term traders and a well designed method to trade such drift can offer a very profitable strategy.



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