Streaks in Earnings Surprises and the Cross-Section of Stock Returns

Published version made available in SMU repository with permission of INFORMS, 2014, February 28</p

Representative agent earnings momentum models: the impact of sequences of earnings surprises on stock market returns under the influence of the Law of Small Numbers and the Gambler's Fallacy

This thesis examines the response of a representative agent investor to sequences (streaks) of quarterly earnings surprises over a period of twelve quarters using the United States S&P500 constituent companies sample frame in the years 1991 to 2006. This examination follows the predictive performance of the representative agent model of Rabin (2002b) [Inference by believers in the law of small numbers. The Quarterly Journal of Economics. 117(3).p.775 816] and Barberis, Shleifer, and Vishny (1998) [A model of investor sentiment. Journal of Financial Economics. 49. p.307 343] for an investor who might be under the influence of the law of small numbers, or another closely related cognitive bias known as the gambler s fallacy. Chapters 4 and 5 present two related empirical studies on this broad theme. In chapter 4, for successive sequences of annualised quarterly earnings changes over a twelve-quarter horizon of quarterly earnings increases or falls, I ask whether the models can capture the likelihood of reversion. Secondly, I ask, what is the representative investor s response to observed sequences of quarterly earnings changes for my S&P500 constituent sample companies? I find a far greater frequency of extreme persistent quarterly earnings rises (of nine quarters and more) than falls and hence a more muted reaction to their occurrence from the market. Extreme cases of persistent quarterly earnings falls are far less common than extreme rises and are more salient in their impact on stock prices. I find evidence suggesting that information discreteness; that is the frequency with which small information about stock value filters into the market is one of the factors that foment earnings momentum in stocks. However, information discreteness does not subsume the impact of sequences of annualised quarterly earnings changes, or earnings streakiness as a strong candidate that drives earnings momentum in stock returns in my S&P500 constituent stock sample. Therefore, earnings streakiness and informational discreteness appear to have separate and additive effects in driving momentum in stock price. In chapter 5, the case for the informativeness of the streaks of earnings surprises is further strengthened. This is done by examining the explanatory power of streaks of earnings surprises in a shorter horizon of three days around the period when the effect of the nature of earnings news is most intense in the stock market. Even in shorter windows, investors in S&P500 companies seem to be influenced by the lengthening of negative and positive streaks of earnings surprises over the twelve quarters of quarterly earnings announcement I study here. This further supports my thesis that investors underreact to sequences of changes in their expectations about stock returns. This impact is further strengthened by high information uncertainties in streaks of positive earnings surprise. However, earnings streakiness is one discrete and separable element in the resolution of uncertainty around equity value for S&P 500 constituent companies. Most of the proxies for earnings surprise show this behaviour especially when market capitalisation, age and cash flow act as proxies of information uncertainty. The influence of the gambler s fallacy on the representative investor in the presence of information uncertainty becomes more pronounced when I examine increasing lengths of streaks of earnings surprises. The presence of post earnings announcement drift in my large capitalised S&P500 constituents sample firms confirms earnings momentum to be a pervasive phenomenon which cuts across different tiers of the stock markets including highly liquid stocks, followed by many analysts, which most large funds would hold

Individual reaction to past performance sequences: evidence from a real marketplace

We use novel data on individual activity in a sports betting market to study the effect of past performance sequences on individual behavior in a real market. The idiosyncratic nature of risk in this market and the revelation of assets’ true terminal values enables us to disentangle whether behavior is caused by sentiment or by superior information about market mispricings and to cleanly test two prominent theories of momentum and reversals—the regime-shifting model of Barberis et al. [Barberis N, Shleifer A, Vishny R (1998) A model of investor sentiment. J. Financial Econom. 49(3):307–343] and the gambler’s/hot-hand fallacy model of Rabin [Rabin M (2002) Inference by believers in the law of small numbers. Quart. J. Econom. 117(3):775–816]. Furthermore, our long panel enables us to study the prevalence across individuals of each type of behavior. We find that (i) three-quarters of individuals exhibit trend-chasing behavior, (ii) seven times as many individuals exhibit behavior consistent with Barberis et al. (1998) as exhibit behavior consistent with Rabin (2002), and (iii) no individuals earn superior returns from momentum trading

Extrapolative Beliefs in Perceptual and Economic Decisions: Evidence of a Common Mechanism

A critical component of both economic and perceptual decision making under uncertainty is the belief-formation process. However, most research has studied belief formation in economic and perceptual decision making in isolation. One reason for this separate treatment may be the assumption that there are distinct psychological mechanisms that underlie belief formation in economic and perceptual decisions. An alternative theory is that there exists a common mechanism that governs belief formation in both domains. Here we test this alternative theory by combining a novel computational modeling technique with two well-known experimental paradigms. We estimate a drift-diffusion model (DDM) and provide an analytical method to decode prior beliefs from DDM parameters. Subjects in our experiment exhibit strong extrapolative beliefs in both paradigms. In line with the common mechanism hypothesis, we find that a single computational model explains belief formation in both tasks and that individual differences in belief formation are correlated across tasks

Essays on Empirical Asset Pricing

This thesis consists of 3 essays on empirical asset pricing. The first and second essays (Chapters 2 and 3) investigate the weak and semi-strong form of market efficiency, respectively, and thus situate themselves in the field of market efficiency research. The first and third essays (Chapters 2 and 4) examine behavioral asset pricing models and intermediary asset pricing models, respectively, and contribute to the definition of market behavior

The Limits of the Market-wide Limits of Arbitrage: Insights from the Dynamics of 100 Anomalies

Financial support from the BNP Paribas Hedge Fund Centre at SMU is gratefully acknowledged</p

Momentum crashes in US stocks, recent evidence during the Covid-19 crisis

Abstract. Cross-sectional momentum has been one of the most persistent return anomalies to provide high levels of abnormal returns in most markets and asset classes over long time periods. While scientific literature is still inconclusive on the core cause of the anomaly, a significant amount of research has been published confirming the existence of abnormal returns related to the phenomenon. Momentum also has its downsides, or its moments, as previous researchers have expressed it. The strategy occasionally experiences large streaks of negative returns, which can wipe out a significant part of the value of momentum portfolios within only a few months. These momentum crashes can take decades to recover from for the strategy and are an important consideration for both researchers and investors seeking to profit from the abnormal returns or diversification benefits that the strategy has provided. As momentum crashes have been found to happen during rebounding markets after market crashes, this thesis studies the momentum crash following the recent market downturn caused by the COVID-19 pandemic and takes a modern look at both momentum and momentum crashes in the US stock market by studying three different momentum strategies formed in previous research with data from January 1990 to March 2022. It also introduces a risk-managed momentum strategy that scales the weights of a traditional 1st decile momentum strategy based on the lagged value of the VIX index compared to its ten-year simple rolling average, up to the previous month. The results show that momentum portfolios had large negative returns in the year following the market downturn caused by the COVID-19 crisis at the start of the year 2020. The negative returns for all studied momentum portfolios were caused by the highly positive returns of the shorted portfolio in the strategy during a market recovery period, similar to prior research results on momentum crashes. The Vix-based risk-managed momentum strategy successfully lowered the effects of momentum crashes compared to its base strategy and provided statistically significant abnormal returns and higher Sharpe ratios compared to the three traditional momentum portfolios throughout the studied time period. Successfully using a lagged value of a market-based index to predict the volatility of momentum has both practical implications, as well as possibly interesting implications for future research on momentum. The traditional 1st decile momentum strategy saw significantly larger losses during momentum crashes compared to 3rd decile momentum strategies; however, the 1st decile portfolio still has higher mean returns than 3rd decile momentum portfolios over a long time period. This suggests that managing the downside risk of aggressive momentum strategies has been extremely important during the 21st century to maximize the benefits of the return anomal