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In a landmark paper Chan, Jagadeesh and Lakonishok (1996) found that both a price momentum inefficiency in shares existed alongside an earnings momentum inefficiency.
Let me translate: there is evidence that by buying shares that had risen significantly in the prior six months you will out-perform the market in the following six month, i.e. that there is price momentum.
Also, there is evidence that if you buy those shares which report unusually high earnings surprises you will out-perform in the following six months.
These two inefficiencies co-exist because they “exploit different pieces of information” with the earnings momentum strategy benefiting from under-reaction to new information on short-term earnings, but the price momentum strategy exploiting Mr Market’s slow reaction to a broader set of information, including longer term profitability.
Method
All US shares between January 1977 and January 1993 were examined every month, put in order based on the criteria and then allocated to deciles (10 x 10% groups).
To calculate the earnings surprise level the most recent quarterly earnings number was compared with the same quarter the year before (then adjusted for volatility in quarterly earnings over the previous 8 quarters).
The company with the largest difference in this “standardized unexpected earnings, SUE”, was placed at the top of the list, followed by the second highest, and so.
Then the entire list of hundreds of companies was split into ten groups: Group 10 has the 10% of shares with the highest SUE, group 1 has the 10% of firms with the lowest SUE.
The stock market performance of these group was then observed for the various periods of time afterwards – I present only the six month results below.
For the price momentum investigation each month shares were ordered based on their last six months returns on the stock market.
Then allocated to 10 groups, with Group 10 containing the top 10% of six-month performers, Group 1 had the lowest (usually fallers). Once the decile portfolios were formed their subsequent performances were observed.
Post-earnings-announcement drift (earnings momentum) results
The chart shows that those companies with the largest jump in earnings show a return of 11.9% in the six months after the announcement day (after the news had already been public knowledge for a good few hours). Those companies with low earnings surprises relative to the same period a year before show a post-announcement day return of 5.1%.
Price momentum results
Those shares which were the wo……………..
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