Reversal in Post-Earnings Announcement Drift

The post-earnings announcement drit (the tendency of stocks to drift in a direction of earnings announcement surprise during next quarter) is a well known effect many times analyzed in an academic literature. However recent research speculates that maybe it is known too much. Arbitrageours started to expoit this anomaly and it seems that effect reversed in the most liquid stocks. Reserach paper by Milian shows that stocks which had the worst return during past earning announcement deliver substantially better return during the days around next earnings announcement. Classical PEAD (post-earnings announcement drift) literature examines mainly quarterly returns therefore it is probable that PEAD still holds. However Milian's work shows a way how to profit from traders over-reaction to a classical anomaly.

Fundamental reason

Academic paper speculates that it seems that due to their well-documented history of apparently underreacting to earnings news, investors are now overreacting to earnings announcement news. However classical PEAD (post-earnings announcement drift) literature examines mainly quarterly portfolio returns while this academic paper focuses on 2-days retun therefore it is probable that PEAD still holds and both anomalies exists concurrently.

Markets traded
equities
Confidence in anomaly's validity
Moderately Strong
Notes to Confidence in anomaly's validity
anomaly is in a opposition to classical PEAD (post-earnings announcement drift) literature, however it is probable that it exists as author of source academic paper concentrates only a 2-day period during earnings announcement while other papers regarding PEAD effect are focused on a 3-month return, therefore both anomalies could exist simultaneously
Period of rebalancing
Daily
Notes to Period of rebalancing
Number of traded instruments
4
Notes to Number of traded instruments
estimated average number of stocks held during one day
Complexity evaluation
Complex strategy
Notes to Complexity evaluation
Financial instruments
stocks
Backtest period from source paper
1996-2010
Indicative performance
40.32%
Notes to Indicative performance
per annum, annualized (aritmethically) daily return of 0.32%, daily return is estimated as 1/4 of 2-day return 1.29%, data from table 4 panel A, daily return is lowered to 1/4 as it can be expected that portfolio would not be held every day (earnings announcements are distributed sporadically during calendar year)
Estimated volatility
not stated
Notes to Estimated volatility
Maximum drawdown
not stated
Notes to Maximum drawdown
Sharpe Ratio
not stated

Keywords:

equity long short, earnings announcement, financial statements effect, stock picking

Simple trading strategy

The investment universe consists of all stocks from NYSE, AMEX and NASDAQ with active option market (so mostly large cap stocks). Each day investor select stocks which would have earnings announcement during next working day. He then checks abnormal performance of these stocks during previous earnings announcement. Investor goes long decile of stocks with the lowest abnormal past earnings announcement performance and goes short stocks with the highest abnormal past performance. Stocks are held for 2 days, portfolio is weighted equally.

Hedge for stocks during bear markets

Not known - Source and related research papers don't offer insight into correlation structure of proposed trading strategy to equity market risk, therefore we do not know if this strategy can be used as a hedge/diversification during time of market crisis. Strategy is built as a long-short, but it can be split into 2 parts. Long leg of strategy is surely strongly correlated to equity market however short-only leg can be maybe used as a hedge during bad times. Rigorous backtest is however needed to determine return/risk characteristics and correlation.

Source Paper

Miliian: Overreacting to a History of Underreaction?
https://www.aeaweb.org/conference/2014/retrieve.php?pdfid=731
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2229479
Abstract:
Prior research has documented a long history of positive autocorrelation in firms’ earnings announcement news. This is one of the main features of the post-earnings announcement drift phenomenon and is typically attributed to investors’ underreaction to earnings news. I document that this autocorrelation has become significantly negative for firms with active exchange-traded options. For these easy-to-arbitrage firms, the firms in the highest decile of prior earnings announcement abnormal return (prior earnings surprise), on average, underperform the firms in the lowest decile by 1.29% (0.73%) at their next earnings announcement. Additional analyses are consistent with investors learning about post-earnings announcement drift and overcompensating. It seems that due to their well-documented history of apparently underreacting to earnings news, investors are now overreacting to earnings announcement news. This paper shows that attempts to exploit a popular trading strategy based on relative valuation can significantly reverse the previously documented pattern.

Hypothetical future performance

Other Papers