Earnings Momentum Research Articles

Anomalies and Financial Distress

This paper explores commonalities across asset-pricing anomalies. In particular, we assess implications of financial distress for the profitability of anomaly-based trading strategies. Strategies based on price momentum, earnings momentum, credit risk, dispersion, idiosyncratic volatility, and capital investments derive their profitability from taking short positions in high credit risk firms that experience deteriorating credit conditions. In contrast, the value-based strategy derives most of its profitability from taking long positions in high credit risk firms that survive financial distress and subsequently realize high returns. The accruals anomaly is an exception - it is robust among high and low credit risk firms in all credit conditions.

The Investment Value of Management Earnings Forecasts

We examine the pricing implications of management earnings forecasts by taking advantage of the unique corporate disclosure practice in Japan, where listed firms regularly announce earnings forecasts upon requests by stock exchanges and the press. A calendar-time strategy using the forecasted earnings-to-price ratio earns a premium comparable to, and separate from, the value premium based on the book-to-market ratio. The premium is robust to a variety of factor and characteristic controls including realized and forecasted earnings momentum. The result is more consistent with characteristic pricing than factor pricing and challenges risk-based explanation.

Are good-news firms riskier than bad-news firms?

This paper examines the relative risk of good-news firms, i.e., those with high standardized unexpected earnings (SUE), and bad-news (low SUE) firms using a stochastic discount factor approach. We find that a stochastic discount factor constructed from a set of basis assets helps explain post-earnings-announcement drift (PEAD). The risk exposures on the pricing kernel increase monotonically from the lowest to highest SUE sorted portfolios. Specifically, good-news firms always have higher risk exposures than bad-news firms in both 10 SUE sorted portfolios and 25 size and SUE sorted portfolios. However, the estimated expected risk premium is too small to explain the observed magnitude of returns on the PEAD strategy. Our risk adjustment can explain only about one-fourth of the total magnitude of the average realized return to the PEAD strategy. As a result, the average risk-adjusted returns of earnings momentum strategies are mostly positive and significant. Overall, our results support the view that at least some portion of the returns to the earnings momentum strategies examined represent compensation for bearing increased risk.

Price and Earnings Momentum, Transaction Costs and Financial Crisis

Price and Earnings Momentum, Transaction Costs and Financial Crisis

The Relation between Earnings and Price Momentum: Does it Vary Across Regimes?

The Relation between Earnings and Price Momentum: Does it Vary Across Regimes?

Momentum

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. Until recently, trading strategies that exploit this phenomenon were consistently profitable in the United States and in most developed markets. Similarly, stocks with high earnings momentum outperform stocks with low earnings momentum. This article reviews the momentum literature and discusses some of the explanations for this phenomenon.

Do Short Sellers Exploit Investors’ Under- and Overreactions?

We examine if short sellers’ reaction to current earnings surprise can be explained by cross-sectional differences in a history of earnings surprises (earnings momentum) or value-glamour characteristics. This study is motivated by our findings that short sellers tend to increase their short positions after both negative and positive earnings surprises, which is anomalous in terms of a post-earnings-announcement-drift (PEAD) story. First, we provide evidence on short sellers’ exploitation of earnings momentum after earnings announcements by showing that short sellers strongly increase their activity in negative-surprise stocks with past positive earnings surprises. Second, when we limit our analysis only to null-surprise stocks, we find that short sellers strongly increase their positions in the null-surprise stocks with past positive earnings surprises, which are likely to be followed by price reversals. Third, we investigate if short sellers increase their short positions in glamour stocks which are associated with investors’ under-reaction (overreaction) to negative (positive) earnings surprises. As expected, the results show that short sellers strongly increase their transactions in glamour stocks following both negative and positive earnings surprises. The overall results provide indirect implications on short sellers’ exploitation of market mispricing driven by investors’ under- and overreactions during the post-announcement period.

In search of momentum profits: are they illusory?

We test whether a Genetic Algorithm (GA) can find profitable investment strategies based on prior stock returns and earnings surprises. We add to the argument whether momentum investing profits are a statistical illusion. The performance of the optimized momentum portfolios is evaluated before and after trading costs, during different time periods, over two market states, and after adjusting for risk. The GA optimization improves the annual returns of the momentum strategies by 2% to 6%. After considering transaction costs, both price and earnings momentum portfolios do not appear to generate abnormal returns. Positive risk-adjusted returns net of trading costs are documented solely in the ‘up’ markets for a portfolio long in prior winners only.

Enhancing the Profitability of Earnings Momentum Strategies: The Role of Price Momentum, Information Diffusion and Earnings Uncertainty

Recent literature indicates that stock characteristics proxying for behavioral biases reinforce the earnings momentum effect. Using data from the investable German HDAX, we analyze whether returns of earnings momentum strategies can be enhanced in a way that not only survives common risk adjustments but also maintains profitability after trading costs. For our liquid stock universe, we find that the rate of information diffusion has the strongest impact. A bivariate sort on earnings momentum and market capitalization yields gross Carhart alphas of up to 22% per year. The abnormal returns are largely robust to reasonable levels of trading costs.

Price and earnings momentum in Australian stock returns

AbstractThere is no prior published Australian research on earnings momentum and only one prior unpublished work of limited depth and scope. We provide some of the first Australian evidence on earnings momentum and revisit price momentum with the first Australian evidence of the behaviour of returns beyond 12 months. Price momentum is found to be a feature of this market, but there is some reversal of returns during the second year after portfolio formation, suggesting trend chasing behaviour. Earnings momentum is also present, but with weak continuation into the second year. Price momentum and earnings momentum are shown to provide independent explanatory power over future returns.

What happened to the quants in August 2007? Evidence from factors and transactions data

Using the simulated returns of long/short equity portfolios based on five valuation factors, we find evidence that the “Quant Meltdown” of August 2007 began in July and continued until the end of 2007. We simulate a high-frequency marketmaking strategy, which exhibited significant losses during the week of August 6, 2007, but was profitable before and after, suggesting that the dislocation was due to market-wide deleveraging and a sudden withdrawal of marketmaking risk capital starting August 8. We identify two unwinds – one on August 1 starting at 10:45am and ending at 11:30am, and a second at the open on August 6, ending at 1:00pm – that began with stocks in the financial sector, long book-to-market, and short earnings momentum.

Rewarding Fundamentals

Over the decades there has been an ubiquitous fixation on earnings power, earnings momentum, earnings announcements, earnings surprises, and the like. The clear explanation is that stock valuations and prices are impacted by earnings changes more than any other phenomenon. Sorensen and Ghosh analyze the hypothetical value of accurate (perfect) earnings forecasting over the past 20 years with lead horizons of 3 to 15 months. The returns for top-quintile stocks ranked by positive earnings relative to forecasts are consistently higher than bottom-quintile stocks that posted earnings below ex ante expectations. The return differentials are extraordinary, consistent over the years, larger with longer forecast horizons, and larger for stocks with tighter ex ante forecasts. <b>TOPICS:</b>Theory, equity portfolio management

Individualism, Uncertainty Avoidance and the Profitability of Momentum Strategies in International Markets

Prior research shows that momentum returns are unlikely to be explained by risk-based theories. Daniel, Hirshleifer, and Subrahmanyam (1998) show that momentum effect can be explained by investors overconfidence and self-attribution bias while Barberis, Shleifer, and Vishny (1998) and Hong and Stein (1999) document that momentum effect can be explained by investors under-reaction to information. Chui et al. (2010) document that cultural differences influence the returns of momentum strategies. Motivated by these studies, we examine the relationship between cognitive biases and the profitability of price and earnings momentum strategies in international markets. Specifically, we address two questions. First, we investigate the relationship between individualism, uncertainty avoidance and price momentum returns. Second, we investigate the relationship between individualism, uncertainty avoidance and earnings momentum returns. Using data from 41 countries we show that (1) the level of individualism in different countries is positively associated with the profitability of price and earnings momentum strategies, (2) the degree of uncertainty avoidance is negatively associated with the earnings momentum profits, but not correlated with price momentum profits. Collectively, our findings suggest that the variation in the profitability of price and earnings momentum strategies can be attributed to cognitive biases.

Do Five Asset Pricing Anomalies Share a Common Mispricing Factor? Multifaceted Empirical Analyses of Failure Risk Proxies, External Financing, and Stock Returns

Assuming that risk premiums are determined by failure risk, we present a stylized model of interactions among risk-proxy variables, external financing, and stock returns in which a common mispricing factor, involving operating profit and external financing, drives the following five asset pricing anomalies: (1) the failure-risk anomaly; (2) earnings momentum; (3) the external financing anomaly; (4) the accruals anomaly; and (5) the book-to-market anomaly. We test the model using panel data on 205 portfolios of U.S. firms (1974-2008). Results for several methodologies all indicate that stock returns are driven by one rational factor, firm size, and one mispricing factor common to anomalies (1), (2), (3), (5) and, to a lesser extent, (4). The common mispricing factor fades with futurity and has strong seasonality.

Post-Earnings Announcement Drift in Spain and Behavioural Finance Models

Our study examines whether behavioural theories can explain post-earnings announcement drift (i.e. earnings momentum) in the Spanish market. In particular, we test models proposed by Barberis et al. (Journal of Financial Economics, 49, pp. 307–343, 1998), Daniel et al. ( Journal of Finance, 53(6), pp. 1839–1885, 1998) and Hong and Stein (Journal of Finance, 54(6), pp. 2143–2184, 1999). Each of these behavioural models draws on two premises – cognitive biases and limits to arbitrage – that we assume will vary with a given country's cultural and institutional features. Therefore, we must exercise caution when extrapolating the favourable results observed in the US market to markets outside of the USA. Our results provide little evidence in support of the hypothesis used to test whether these models can indeed explain the earnings momentum anomaly in the Spanish market. We believe some characteristics of the Spanish market, such as its lower score on the Individualism Index, lower levels of investor protection and code-law-based legal system, may explain why our results differ from those obtained in the USA.

Individualism, Uncertainty Avoidance, and Earnings Momentum in International Markets

The literature shows that price and earnings momentum returns cannot be fully explained by risk-based theories. In an attempt to better understand the price momentum anomaly, Chui et al. [2010] document that the cultural factor of ― individualism influences price momentum returns, but that the cultural factor of ― uncertainty avoidance‖ does not. The current study extends Chui et al. [2010] by examining the influence of individualism and uncertainty avoidance on earnings momentum profits, as theory suggests that unique characteristics associated with earnings momentum, relative to price momentum, give rise to significant effects for both these cultural factors. Using data from 41 countries, we show that the level of individualism in a country is positively associated with earnings momentum profits and that the level of uncertainty avoidance is negatively associated with earnings momentum profits. This study contributes to the ongoing quest to better understand the earnings momentum phenomenon.

Individualism, Uncertainty Avoidance, and Earnings Momentum in International Markets

Individualism, Uncertainty Avoidance, and Earnings Momentum in International Markets

Dynamic Corporate Capital Stocks: Cross-sectional and Inter-temporal Stock Return Patterns

We investigate a general multiple security equilibrium model in which firms adjust their capital stock in response to economic shocks. Asset values are determined by competitive risk-averse investors. When corporate capital increases in value, firms react by creating more of it. This leads to additional risk that must be borne by investors. Overall, the model generates a VAR(1) structure for the state variables determining the cross-section of expected returns, and is broadly consistent with stylized facts (e.g., the value premium, size premium, earnings momentum, and investment premium). In addition, the paper tests a new prediction of the model and finds support for it in the data.

Liquidity and the Post-Earnings-Announcement Drift

The post-earnings-announcement drift is a longstanding anomaly that conflicts with market efficiency. This study documents that the post-earnings-announcement drift occurs mainly in highly illiquid stocks. A trading strategy that goes long high-earnings-surprise stocks and short low-earnings-surprise stocks provides a monthly value-weighted return of 0.04 percent in the most liquid stocks and 2.43 percent in the most illiquid stocks. The illiquid stocks have high trading costs and high market impact costs. By using a multitude of estimates, the study finds that transaction costs account for 70–100 percent of the paper profits from a long–short strategy designed to exploit the earnings momentum anomaly.

Forecast Accuracy Uncertainty and Momentum

We demonstrate that stock price momentum and earnings momentum can result from uncertainty surrounding the accuracy of cash flow forecasts. Our model has multiple information sources issuing cash flow forecasts for a stock. The investor combines these forecasts into an aggregate cash flow estimate that has minimal mean-squared forecast error. This aggregate estimate weights each cash flow forecast by the estimated accuracy of its issuer, which is obtained from their past forecast errors. Momentum arises from the investor gradually learning about the relative accuracy of the information sources and updating their weights. Empirical tests validate the model's prediction of stronger momentum in stocks with large information weight fluctuations and high forecast dispersion. We also identify return predictability attributable to changes in the information weights.