The Post Earnings Announcement Effect Drift (PEAD), is a well known market anomaly that has been documented in various studies of both US and international markets going as far back as 1968. PEAD is the tendency for a stock’s cumulative abnormal returns to drift after earnings announcements, sometimes for a few weeks, sometimes for several months. This phenomenon is more extreme in small caps.
Multiple academics have attempted to figure out why PEAD continues to reoccur. In Earnings Announcements Are Full of Surprises the author’s have three main insights:
- Market underreaction to information at the earnings announcement date extends beyond earning news.
- Market participants don’t correctly value non-financial information.
- The announcement return can lead to predictable returns in the future. Might be related to lack of understanding of “time series properties of earnings.”
Studies of PEAD have also found interesting insights into the behavior of market participants around earnings announcements. For example, trading volume around earnings announcements provides insights into how much disagreement there is among market participants concerning the earnings number.
We find that unexpected trading volume at the earnings announcement positively correlates with future returns. In other words, higher opinion divergence at the earnings date is associated with more positive returns during the post-announcement period. This evidence is consistent with predictions from Varian (1985), who posits that under reasonable conditions1 , asset prices will be lower when investors’ opinions are more dispersed.
A Better Way To Play Earnings Surpises
Although quarterly earnings surprises are a short term phenomenon, they can have lasting effects on an equity investor’s return. This is both an opportunity, and a threat to long term focused investors.
If an investor has high conviction in their quarterly forecast, PEAD provides a short term boost and a medium term tailwind. If they want to increase leverage they could consider a strategy involving call options in the underlying stock. However this still might not be the best way to boost returns. Investors might have high conviction in their forecast but there could be confounding factors that influence the stock price in a different direction.
If one has an edge in predicting earnings, using Earnings Derivatives® , that is buying an option on the earnings number might be a better choice. Similarly, there are situations where a company might beat on revenue, and miss on earnings (or vice versa). In this case an investor can buy calls and/or sell puts on revenue, and buy a put and/or sell a call on earnings. For skilled financial analysts, the possibilities for alpha generation are practically endless.