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Earnings Autocorrelation and the Post-Earnings-Announcement Drift Josef Fink a , Stefan Palan a , and Erik Theissen b,a a Department of Banking and Finance, University of Graz b Business School, University of Mannheim Austrian Working Group on Banking and Finance | University of Liechtenstein | November 22, 2019

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Page 1: Earnings Autocorrelation and the Post-Earnings ...€¦ · Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 3 View in the literature − Risk-based

Earnings Autocorrelation and the Post-Earnings-Announcement Drift

Josef Finka, Stefan Palana, and Erik Theissenb,a

a Department of Banking and Finance, University of Graz b Business School, University of Mannheim

Austrian Working Group on Banking and Finance | University of Liechtenstein | November 22, 2019

Page 2: Earnings Autocorrelation and the Post-Earnings ...€¦ · Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 3 View in the literature − Risk-based

Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 1

Eugene Fama

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Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 1

Eugene Fama Image source: Nyman, B., 2013, accessed : 17.10.2019, https://commons.wikimedia.org/wiki/File:Eugene_Fama_at_Nobel_Prize,_2013.jpg.

Page 4: Earnings Autocorrelation and the Post-Earnings ...€¦ · Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 3 View in the literature − Risk-based

Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 1

Eugene Fama Image source: Nyman, B., 2013, accessed : 17.10.2019, https://commons.wikimedia.org/wiki/File:Eugene_Fama_at_Nobel_Prize,_2013.jpg.

Page 5: Earnings Autocorrelation and the Post-Earnings ...€¦ · Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 3 View in the literature − Risk-based

Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 1

Eugene Fama Image source: Nyman, B., 2013, accessed : 17.10.2019, https://commons.wikimedia.org/wiki/File:Eugene_Fama_at_Nobel_Prize,_2013.jpg.

Page 6: Earnings Autocorrelation and the Post-Earnings ...€¦ · Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 3 View in the literature − Risk-based

Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 1

Eugene Fama Image source: Nyman, B., 2013, accessed : 17.10.2019, https://commons.wikimedia.org/wiki/File:Eugene_Fama_at_Nobel_Prize,_2013.jpg.

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Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 2

Motivation

Ball and Brown (1968):

− Prices drift upward after positive and downward

after negative earnings surprises

− Long duration: up to one year

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Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 3

View in the literature

− Risk-based explanations cannot explain PEAD (Ball, Kothari and Watts, 1993; Kim and Kim, 2003)

− Multifactor models cannot explain PEAD (Sadka, 2006; Francis et al., 2007; Chordia et al., 2009; Hou, Xue and Zhang,

2015)

− Majority view: PEAD is a mispricing phenomenon (Fama, 1998; Richardson, Tuna and Wysocki, 2010; Hung, Li and

Wang, 2015)

− Economic significance: institutional investors exploit PEAD, earning 22% mean annualized

excess return (Ke and Ramalingegowda, 2005)

Page 9: Earnings Autocorrelation and the Post-Earnings ...€¦ · Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 3 View in the literature − Risk-based

Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 4

Potential causes

− Misspecified model for forecasting earnings (Bernard and Thomas, 1989; Freeman and Tse, 1989; Bernard and

Thomas, 1990)

− Inattention (Hou, Peng and Xiong, 2009; Hung, Li and Wang, 2015), possibly joint with firm size (Foster, 1977; Bernard

and Thomas, 1989; Bathke et al., 2014)

− Positive serial correlation in quarterly earnings (Bernard and Thomas, 1989; Bernard and Thomas, 1990; Rendleman,

Jones and Latane, 1987; Ball and Bartov, 1996; Rangan and Sloan, 1998; Battalio and Mendenhall, 2005; Bathke, Lorek and Lee Willinger, 2006;

Bathke et al., 2014; Chang et al., 2017; Chung and Hrazdil, 2011)

− Frictions prevent arbitrage (Bernard and Thomas, 1989; Ball, 1992; Ravi Bhushan, 1994; Mendenhall, 2004; Sadka, 2006; Cohen

et al., 2007; Ng, Rusticus and Verdi, 2008; Chordia et al., 2009; Chung and Hrazdil, 2011)

Page 10: Earnings Autocorrelation and the Post-Earnings ...€¦ · Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 3 View in the literature − Risk-based

Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 5

Contribution

− First study in the experimental lab

− Full control over fundamental value, information, risk, timing …

− Ceterus paribus test of the role of earnings autocorrelation

− Focus on behavioral biases, ruling out confounds

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Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 6

Experimental design: Markets

− Two firms/stocks: A and B

− Simultaneous continuous double auction markets following NASDAQ rules

(z-Tree, GIMS; Fischbacher, 2007; Palan, 2015)

− Endowments: 900 talers plus 9 shares of A or B

− Short-selling of 9 shares and buying on margin of 900 talers possible

Page 12: Earnings Autocorrelation and the Post-Earnings ...€¦ · Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 3 View in the literature − Risk-based

Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 7

Experimental design: Assets

− Initially expected earnings per share: 𝐸 = 5 talers, corresponding to 𝐹𝑉0 = 100 talers

− In each announcement, earnings change by Δ𝐸 ∈ {δ− = −0.5, δ+ = 0.5}

− Earnings of firms A and B are perfectly negatively correlated

− Equal numbers of firm A and B shares in the market ⇒ no aggregate risk

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Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 8

Experimental design: Period structure

− 4 trading periods à 900s

− First earnings announcement

180s after period start

− Consecutive announcements every 180s

− Final announcement at period close

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Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 9

Treatment BASE

− All transition probabilities equal 0.5

− No earnings autocorrelation: 𝑅Δ𝐸,Δ𝐸𝐵𝑎𝑠𝑒 (𝜏 − 1, 𝜏) = 0

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Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 10

Treatment CORR

− Positive earnings autocorrelation:

𝑅Δ𝐸,Δ𝐸𝐶𝑜𝑟𝑟 (τ − 1, τ) = 0.5

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Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 11

Further design details

− Subjects are business and economics students

− 8 (of 10) sessions of BASE, 8 (of 15) sessions of CORR

− 12 traders per session, 190* (298) in total

− Average payoff: €24.90 (sd €3.64)

* Two of the original 16 sessions had only 11 instead of 12 traders due to no-shows.

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Results

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Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 12

Evidence on Post-Earnings-Announcement Drift

− Log return relative to bid-ask midpoint at the

time of the earnings announcement

− Points indicate ending value of 10s windows

− First 10s constitute announcement window

− Dashed lines indicate return levels reached by

the end of the announcement window

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Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 13

Evidence on Post-Earnings-Announcement Drift

− Separate data for treatments

BASE and CORR

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Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 14

Evidence on Post-Earnings-Announcement Drift

− Data only from treatment CORR

− Surprise: sign of earnings

change switches compared to

preceding announcement

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Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 15

Paper returns to PEAD investment

− Mean returns from end of announcement window until end of phase (t-statistics in

parentheses)

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Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 16

Interim conclusions

− Result 1. There is PEAD following both positive and negative earnings news.

− Result 2. There is PEAD when earnings are not autocorrelated, but PEAD is larger with

autocorrelation.

− Result 3. Announcements of unexpected earnings news are followed by significantly

greater PEAD than announcements confirming expectations.

Page 23: Earnings Autocorrelation and the Post-Earnings ...€¦ · Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 3 View in the literature − Risk-based

Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 17

Trading strategies

Strategy

Following an announcement with

positive earnings news, submit a

limit buy order priced at the bid-ask

price midpoint. If this order gets

executed, hold the position until the

end of the period and earn FV for

each share held. Following an

announcement with negative

earnings news, do the opposite.

Page 24: Earnings Autocorrelation and the Post-Earnings ...€¦ · Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 3 View in the literature − Risk-based

Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 17

Trading strategies

Strategy

Following an announcement with

positive earnings news, submit a

limit buy order priced at the bid-ask

price midpoint. If this order gets

executed, hold the position until the

end of the period and earn FV for

each share held. Following an

announcement with negative

earnings news, do the opposite.

Page 25: Earnings Autocorrelation and the Post-Earnings ...€¦ · Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 3 View in the literature − Risk-based

Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 18

Interim conclusions

− Result 4. There are trading strategies which can profitably exploit the observed PEAD,

net of transaction costs.

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Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 19

Price adjustment

− Percentage adjustment of closing bid-ask midpoint

prices from pre-announcement price levels to pre-

announcement price levels plus change in 𝐹𝑉

− Clear evidence of delayed and incomplete

adjustment

Page 27: Earnings Autocorrelation and the Post-Earnings ...€¦ · Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 3 View in the literature − Risk-based

Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 20

Price adjustment

− Separate data for treatments BASE and CORR

− Surprising/Unsurprising looks similar to CORR

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Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 21

Interim conclusions

− Result 5. Prices generally exceed the fundamental value in our markets.

− Result 6. The observed mispricing allows for profitable arbitrage.

− Result 7. Prices adjust slowly and incompletely to changes in fundamental values.

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Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 22

Conclusion

− First experimental examination of Post-Earnings-Announcement drift

− Clear evidence of PEAD even in a simplified lab environment

− Stronger drift in the presence of earnings autocorrelation

− Stronger drift following surprising than unsurprising announcements

− More complete adjustment in CORR than in BASE

− More complete adjustment following Unsurprising than following Surprising

announcements

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Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 23

Outlook

− Impact of algorithmic arbitrage

− Impact of frictions

− Impact of announcement time (during/after trading hours)

− Microstructure of PEAD

This project was funded by the Austrian Science Fund – FWF, Grant no. P 32124-G27.

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Earnings Autocorrelation and the Post-Earnings-Announcement Drift

Josef Finka, Stefan Palana, and Erik Theissenb,a

a Department of Banking and Finance, University of Graz b Business School, University of Mannheim

Austrian Working Group on Banking and Finance | University of Liechtenstein | November 22, 2019

Page 32: Earnings Autocorrelation and the Post-Earnings ...€¦ · Earnings Autocorrelation and the Post-Earnings-Announcement Drift (Fink, Palan, Theissen) 3 View in the literature − Risk-based

References

Ball, R., 1992. The earnings-price anomaly, Journal of Accounting and Economics 15(2-3), 319–345. Ball, R., Bartov, E., 1996. How naive is the stock market's use of earnings information?, Journal of Accounting and Economics 21(3), 319–337. Ball, R., Brown, P., 1968. An Empirical Evaluation of Accounting Income Numbers, Journal of Accounting Research 6(2), 159–178. Ball, R., Kothari, S. P., Watts, R. L., 1993. Economic Determinants of the Relation Between Earnings Changes and Stock Returns, Accounting Review

68(3), 622–638. Bathke, A. W., Lorek, K. S., Lee Willinger, G., 2006. The Security Market's Reaction to Firms’ Quarterly Earnings Evidencing Varying Degrees of

Autocorrelation, Advances in Accounting 22, 29–43. Bathke, A. W., Morton, R. M., Notbohm, M., Zhang, T., 2014. Objective estimation versus subjective perceptions of earnings patterns and post-

earnings-announcement drift, Accounting & Finance 54(2), 305–334. Battalio, R. H., Mendenhall, R. R., 2005. Earnings expectations, investor trade size, and anomalous returns around earnings announcements, Journal

of Financial Economics 77(2), 289–319. Bernard, V. L., Thomas, J. K., 1989. Post-Earnings-Announcement Drift: Delayed Price Response or Risk Premium?, Journal of Accounting Research 27,

1. Bernard, V. L., Thomas, J. K., 1990. Evidence that stock prices do not fully reflect the implications of current earnings for future earnings, Journal of

Accounting and Economics 13(4), 305–340. Bock, O., Baetge, I., Nicklisch, A., 2014. hroot: Hamburg Registration and Organization Online Tool, European Economic Review 71, 117–120. Chang, T. Y., Hartzmark, S. M., Solomon, D. H., Soltes, E. F., 2017. Being Surprised by the Unsurprising: Earnings Seasonality and Stock Returns, Review

of Financial Studies 30(1), 281–323.

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Chordia, T., Goyal, A., Sadka, G., Sadka, R., Shivakumar, L., 2009. Liquidity and the Post-Earnings-Announcement Drift, Financial Analysts Journal 65(4), 18–32.

Chung, D. Y., Hrazdil, K., 2011. Market Efficiency and the Post-Earnings Announcement Drift*, Contemporary Accounting Research 28(3), 926–956. Cohen, D. A., Dey, A., Lys, T. Z., Sunder, S. V., 2007. Earnings announcement premia and the limits to arbitrage, Journal of Accounting and Economics

43(2), 153–180. Fama, E. F., 1998. Market efficiency, long-term returns, and behavioral finance, Journal of Financial Economics 49(3), 283–306. Fischbacher, U., 2007. z-Tree: Zurich toolbox for ready-made economic experiments, Experimental Economics 10, 171–178. Foster, G., 1977. Quarterly Accounting Data: Time-Series Properties and Predictive-Ability Results, Accounting Review 52(1), 1–21. Francis, J., Lafond, R., Olsson, P., Schipper, K., 2007. Information Uncertainty and Post-Earnings-Announcement-Drift, Journal of Business Finance &

Accounting 34(3-4), 403–433. Frazzini, A., 2006. The Disposition Effect and Underreaction to News, The Journal of Finance 61(4), 2017–2046. Freeman, R. N., Tse, S., 1989. The Multiperiod Information Content of Accounting Earnings: Confirmations and Contradictions of Previous Earnings

Reports, Journal of Accounting Research 27, 49. Hou, K., Peng, L., Xiong, W., 2009. A Tale of Two Anomalies: The Implications of Investor Attention for Price and Earnings Momentum, Working paper. Hou, K., Xue, C., Zhang, L., 2015. Digesting Anomalies: An Investment Approach, Review of Financial Studies 28(3), 650–705. Hung, M., Li, X., Wang, S., 2015. Post-Earnings-Announcement Drift in Global Markets: Evidence from an Information Shock, The Review of Financial

Studies 28(4), 1242–1283. Ke, B., Ramalingegowda, S., 2005. Do institutional investors exploit the post-earnings announcement drift?, Journal of Accounting and Economics

39(1), 25–53. Kim, D., Kim, M., 2003. A Multifactor Explanation of Post-Earnings Announcement Drift, The Journal of Financial and Quantitative Analysis 38(2), 383. Mendenhall, R. R., 2004. Arbitrage Risk and Post‐Earnings‐Announcement Drift, The Journal of Business 77(4), 875–894. Ng, J., Rusticus, T. O., Verdi, R. S., 2008. Implications of Transaction Costs for the Post–Earnings Announcement Drift, Journal of Accounting Research

46(3), 661–696. Palan, S., 2015. GIMS - Software for Asset Market Experiments, Journal of Behavioral and Experimental Finance 5, 1–14.

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Rangan, S., Sloan, R. G., 1998. Implications of the Integral Approach to Quarterly Reporting for the Post-Earnings-Announcement Drift, Accounting Review 73(3), 353–371.

Ravi Bhushan, 1994. An informational efficiency perspective on the post-earnings announcement drift, Journal of Accounting and Economics 18(1), 45–65.

Rendleman, R. J., Jones, C. P., Latane, H. A., 1987. Further Insights into the Standardized Unexpected Earnings Anomaly: Size and Serial Correlation Effects, The Financial Review 22(1), 131–144.

Richardson, S., Tuna, İ., Wysocki, P., 2010. Accounting anomalies and fundamental analysis: A review of recent research advances, Journal of Accounting and Economics 50(2-3), 410–454.

Sadka, R., 2006. Momentum and post-earnings-announcement drift anomalies: The role of liquidity risk, Journal of Financial Economics 80(2), 309–349.

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Screenshot trading screen

− Red captions are

translations not visible

during the experiment

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Trading strategies

− Figure shows spreads in the 10s

following the announcement, and

at the close of the phase

− Large spreads at both open and

close of the strategy

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Mispricing

− Measures of mispricing:

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Arbitrage

− Sum of stock A’s and stock B’s values is always 200 talers

− Clear arbitrage opportunity whenever:

− Sum of best bids of

stocks A and B

exceeds 200 talers

− Sum of best asks of

stocks A and B falls

short of 200 talers

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Price adjustment

− Separate data for surprising and unsurprising announcements in phases 3-5 of treatment

CORR

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Spreads

− Spreads around 𝐹𝑉 reflect overpricing

(at least at the beginning of a period)

− Spreads generally decline over time

within a period

− Spreads also decline over time within

phases