Earnings Momentum Research Articles

Information Uncertainty and Expected Returns

This study examines the role of information uncertainty (IU) in predicting cross-sectional stock returns. We define IU in terms of “value ambiguity,” or the precision with which firm value can be estimated by knowledgeable investors at reasonable cost. Using several different proxies for IU, we show that (1) on average, high-IU firms earn lower future returns (the “mean” effect), and (2) price and earnings momentum effects are much stronger among high-IU firms (the “interaction” effect). These findings are consistent with analytical models in which high IU exacerbates investor overconfidence and limits rational arbitrage.

Earnings and Price Momentum

This paper examines whether earnings momentum and price momentum are related. Both in time-series as well as in cross-sectional asset pricing tests, we find that price momentum is captured by the systematic component of earnings momentum. The predictive power of past returns is subsumed by a zero-investment portfolio that is long on stocks with high earnings surprises and short on stocks with low earnings surprises. Further, returns to the earnings-based zero-investment portfolio that is long on stocks with high earnings surprises. Further, returns to the earnings-based zero-investment portfolio are significantly related to future macroeconomic activities, including growth in GDP, industrial production, consumption, labor income, inflation, and T-bill returns. Our results have implications for the Carhart four-factor model and suggest that the price-momentum factor in the Carhart model is merely a noisy proxy for the earnings-momentum based hedge portfolio, PMN.

Firm Characteristics, Industry, Horizon and Time Effects, in the Cross-Section of Expected Stock Returns

We construct a panel data model to explain the cross-section of individual stock returns, using monthly data for 1,880 large US firms for 1985-2005. Model specification is geared towards multiple explanatory variables, poolability across industries, alternative forecast horizons, and the effects of unobserved heterogeneity among firms. We find that combining multiple firm characteristics increases the predictive power. High expected returns are mostly related to size, cashflow-to-price and turnover, and somewhat to earnings revisions and momentum. Diversified portfolios sorted on expected returns have moderate risk exposures and generate significant risk-adjusted returns over all horizons. Longer forecasting horizons drastically reduce portfolio turnover and hence lower costs.

Global Momentum Strategies

Here are some practical perspectives on momentum investing in stocks internationally. Momentum is generally more profitable on the long side than on the short side, making it accessible to a broad range of institutional capital, and both price and earnings momentum profits are significant globally. Earnings momentum internationally is distinct from price momentum; using price and earnings momentum in conjunction produces greater economic profits. Momentum profits co–move more weakly across markets than market indexes. Interestingly, while market correlations are much higher in down markets than in up markets, momentum correlations are low under both market conditions. There is no appreciable difference in momentum strategy profitability in up and down markets, which means timing is less important to momentum traders. Finally, momentum strategies are not riskless? there are often periods of several months when they have netted low or negative returns. The findings altogether suggest that momentum is useful in international portfolio management, but it should be implemented very thoughtfully.

Pension Plan Funding and Stock Market Efficiency

As a consequence of the recent bear stock market, the aggregate funding level of defined benefit pension plans has tremendously deteriorated. A relevant issue is whether the market value of the firms sponsoring these plans reflects their pension liabilities. In sharp contrast with earlier studies, this paper presents evidence indicating that the market has significantly overpriced firms with severely underfunded pension plans. We show that these companies earn lower stock returns than firms with healthier pension plans, and the underperformance persists for at least five years after the first emergence of the large underfunding. Moreover, the low returns are not explained by risk, return momentum, earnings momentum, or accruals. For this reason, we conclude that we have identified an additional layer of mispricing. We propose an explanation where investors do not anticipate the impact of the pension liability on future earnings and cash flows, and they are surprised when the negative implications of underfunding finally materialize. Consistent with this view, we provide significant evidence of market surprises for severely underfunded firms. Finally, we characterize these firms as past losers which, although value companies, pay low returns.

Information Uncertainty and Expected Returns

This study examines the role of information uncertainty (IU) in predicting cross-sectional stock returns. We define IU in terms of value ambiguity, or the precision with which firm value can be estimated by knowledgeable investors at reasonable cost. Using several different proxies for IU, we show that: (1) On average, High-IU firms earn lower future returns (the mean effect), and (2) Price and earnings momentum effects are much stronger among high-IU firms (the interaction effect). These findings are consistent with theoretical models that feature investor overconfidence (Daniel et al. (1998)) and informational cascades (Bikhchandani et al. (1992)). Specifically, our evidence indicates that high IU exacerbates investor overconfidence and limits rational arbitrage.

Global Momentum Strategies: A Portfolio Perspective

We provide practical perspectives on momentum investing in stocks internationally. First, momentum is generally more profitable on the long side than on the short side, making it accessible to a broad range of institutional capital. Second, both price and earnings momentum profits are significant globally. Third, internationally, earnings momentum is distinct from price momentum, and using price and earnings momentum in conjunction produces larger economic profits. Fourth, momentum profits have weaker co-movements across markets than market indices. Interestingly, while market correlations are much higher in down markets than in up markets, momentum correlations are low in both market conditions. Fifth, momentum strategies do not differ appreciably in profitability between up and down markets, which means timing is less important to momentum traders. Finally, momentum strategies are not riskless-historically there have often occurred periods of several months where they have netted low or negative returns. Altogether, these findings suggest that momentum is useful in international portfolio management, but its implementation should be thoughtfully considered.

Analyst Underreaction in the United Kingdom

We revisit the debate on the interpretation given to prior-year earnings changes in predicting analysts' future forecast errors. We advance a new specification of this relation that distinguishes between earnings reversion and momentum. For a large UK dataset for the years 1990-1996, we find substantial underreaction, particularly in situations of earnings momentum. We find that underreaction is further increased for cases of downward earnings momentum when the analyst's merchant bank acts as a broker to the company. We interpret this as a reporting bias caused by an analyst's response to bad news being compromised.

Dispersion in Analyst Forecasts and the Profitability of Earnings Momentum Strategies

This paper shows that the dispersion in analysts’ consensus forecasts contains incremental information to predict future stock returns. Consistent with prior research, stock prices in the German market underreact to news about future earnings and drift in the direction suggested by analysts’ forecasts revisions. Even higher abnormal returns can be achieved by applying such an earnings momentum strategy to stocks with a low dispersion in analyst forecasts. These results support one of the recent behavioural models in which investors underweight new evidence and conservatively update their beliefs in the right direction, but by too little in magnitude with respect to more objective information.

Discussion of “Momentum and Autocorrelation in Stock Returns”: Table 1

Jegadeesh and Titman (1993) document individual stock momentum: strategies that buy stocks that have performed relatively well in the past and sell stocks that have performed relatively poorly in the past generate significant positive returns over the 3- to 12-month horizon. This finding, obtained using data from the U.S. market, also holds for a number of international markets [e.g., Haugen and Baker (1996), Rouwenhorst (1998)]. What are the economic mechanisms behind individual stock momentum? One approach to answering this question is to relate momentum to other factors driving the cross section of expected stock returns. A number of findings have emerged. Adjustments for factors such as the Fama and French three-factor model tend to strengthen, rather than explain, momentum [e.g., Fama and French (1996), Grundy and Martin (2001)]. Contrary to the finding of Conrad and Kaul (1998), cross-sectional differences in expected returns is not an important cause of momentum [e.g., Jegadeesh and Titman (1993), Grundy and Martin (2001)]. And contrary to the finding of Moskowitz and Grinblatt (1999), a number of subsequent articles find that industries (or industry effects) do not explain momentum [e.g., Asness, Porter, and Stevens (2000), Lee and Swaminathan (2000), Grundy and Martin (2001)]. Stock price momentum is partially related to earnings momentum, but both past returns and public earnings surprises (in a multiple regression) help to predict subsequent returns at horizons of six months to a year [e.g., Chan, Jegadeesh, and Lakonishok (1996)].

Earnings Momentum Strategies and the Macroeconomy

This paper documents that earnings momentum strategies are systematically related to the macroeconomy. The returns to these strategies are predictable by standard macroeconomic and aggregate financial market variables. What's more, a significant fraction of the variation in the profits to these strategies appears to be negatively associated with news about macroeconomic aggregates such as industrial production growth and consumption growth. Existing explanations for the earnings momentum phenomenon, whether rational or behavioral, have difficulty explaining all of these facts.

Dispersion in Analyst Forecasts and the Profitability of Earnings Momentum Strategies

It is a well documented phenomenon that stock prices underreact to news about future earnings and drift in the direction suggested by revisions in analysts' earnings forecasts. This paper shows that the dispersion in analysts' consensus forecasts contains incremental information to predict future stock returns. Higher abnormal returns can be achieved by applying an earnings momentum strategy to stocks with a low dispersion. This finding supports one of the recent behavioral models in which investors focus too little on the weight of new evidence and conservatively update their beliefs in the right direction, but by too little in magnitude with respect to more objective information.

The Profitability of Momentum Strategies

Momentum strategies based on continuations in stock prices have attracted a wide following among money managers and investors. We evaluated the profitability of price momentum strategies based on past return and earnings momentum strategies based on standardized unexpected earnings and revisions of consensus forecasts. The strategies proved to be profitable for intermediate horizons. Chasing momentum can generate high turnover, however; hence, implementation of momentum strategies requires a focus on managing trading costs. Comparing the strategies yielded evidence that they reflect distinct phenomena and provided information about the sources of profits. The results indicate that the market is slow to incorporate the full impact of information in its valuations.

Accounting‐Based Stock Price Anomalies: Separating Market Inefficiencies from Risk*

Abstract. We examine six accounting‐based stock price anomalies using two sets of tests to determine the extent to which the anomalies (1) represent market mispricing or (2) reflect premia for unidentified risks. Market mispricing is indicated if the anomalous returns are concentrated around subsequent earnings announcements in patterns suggesting that the earnings information causes traders to re‐examine their prior (incorrect) beliefs. Mispricing is also indicated if anomalous returns on zero‐investment portfolios are positive, period after period. Our results indicate that an anomaly based on earnings momentum probably reflects market mispricing, but that two value‐glamour anomalies (based on the book‐market ratio and the earnings‐price ratio), and two anomalies based on computerized fundamental analyses (from Ou and Penman 1989 and Holthausen and Larcker 1992) are more likely to reflect risk premia than indicated by prior research. Evidence on a sixth anomaly, based on price momentum, is mixed.

Chemical Producers' Earnings Remain Strong, But Continue To Fall From Peak

First, the good news: Aggregate earnings of U.S. chemical companies increased for the 10th straight quarter. Now, the not so good news: The 45% rise in earnings for 30 major chemical companies tracked by C&EN fell below the 63% gain achieved in the second quarter and the 89% rise attained in the first quarter. Earnings of the 30 companies totaled $2.11 billion in this year's third quarter. Other indications also confirm a softening in the earnings momentum in the chemical industry, paralleling the sluggishness of the overall U.S. economy. Total sales for the 30 chemical companies reached $21.9 billion in the third quarter, up 10% from third-quarter 1994. But sales growth fell below the 19% rate posted in this year's second quarter and the 23% growth in the first quarter. For the first nine months of 1995, the 30 companies posted aggregate sales of more than $68.7 billion, an 18% gain from the first nine ...

Growth Stock Investing Today

During the past 40 years, growth stock investing has involved being in the right place at the right time and being patient in the face of unfavorable developments. Can growth stock investors rely on past practices in the future? Certain principles of growth investing seem to be timeless, but changes in the investment environment are making the identification of growth stocks harder than in the past and producing changes in several attitudes and practices of growth stock investors—from the definition of earnings momentum to analyzing pricing strategy to the location of tomorrow’s entrepreneurs.This presentation comes from the Equity Investing: Value and Growth conference held in New York, New York, on February 15, 1995.

Chemical Companies9 Cash Rose Markedly Last Year

In these days of rapidly increasing corporate profits in the chemical industry, there is only so much that companies can do with the cash that they are receiving. They can increase dividends, they can use it to modernize plants, they can pay down debt, or they can hold on to it. And U.S. chemical firms seem to be doing all of these—but especially they are holding on to their money. A C&EN survey of 20 U.S. chemical companies shows that the total of cash and marketable securities and current assets increased markedly in 1987 and current liabilities increased much more slowly. The result was increasing liquidity ratios for the firms. The pattern among the companies is following that usually seen well into an economic recovery. The earnings momentum is providing cash for the chemical companies fast enough that they are having trouble getting rid of it. At the same time, however, current liabilities, the day-to-day ...