The cockroach theory | stockbee

5/01/2009

The cockroach theory

When a company has a earnings surprise or a miss, more are likely to follow. That is called the cockroach effect. So when you see one earnings surprise from a company more are likely to follow. That is what produces big trends. When you have one isolated company in a sector with earnings surprise, you can ignore it. But when you have so many companies in a sector coming out with surprise, take note. 
  
You will rarely find a single earnings surprise, in most cases the company continues to beat earnings for few more seasons. The reason is that earnings surprise can often signal a change in the long-term outlook for future earnings. Earnings surprise also signal change on underlying business conditions. they signal sector dynamics has changed. research shows if a company beats earnings, the probability of it beating earnings next season increases to .

Some of the most powerful and enduring trends lasting months or years are set in motion by earning acceleration or deceleration. If you look at any long term trend in stock or sector, you will find at the beginning of the trend a series of earnings surprise or acceleration. The oil stocks started showing significant earning acceleration in 2003 and the trend lasted for 4 years. The steel stocks started showing earnings surprise in 2003 that trend lasted 4 years. So when you have a sector showing earnings surprises take note.

Earnings and sales growth are the fuel which drive prices high in most stocks. While average traders are chart monkeys trying to make money by reading charts, the institutional players are driven completely by earnings and valuation. If you talk to a mutual fund manager or pension fund manager, they will first talk of earnings power and valuation. 

 PEAD or Post Earnings Announcement drift anomaly was documented in academic literature for first time in 1968. 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. 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.The reason for PEAD are many and behavior finance professionals have explained the phenomenon as under reaction or overreaction. Analyst, investors and funds at first underact to surprises. Because it does not gel with their currently held belief and so they dismiss it at first there is a classic cognitive dissonance at work. 

The best book on earnings and how to trade earnings is by Mitch Zacks of Zacks.com Ahead of the Market: The Zacks Method for Spotting Stocks Early -- In Any Economy
The only problem with the book is blatant self promotion which can get on your nerves. But it explains the earnings phenomenon best. 



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