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Momentum Strategies

1693

Table III-Con tin ued

(Low) 2 3 4 5 6

10 (High)

Panel E: Revision in Analyst Forecasts (%)

Most recent revision Average over next 6

months Average from months 7

to 12

-1.558 -0.903 -0.547 -0.626 -0.268 -0.125 -1.480 -0.866 -0.647 -0.453 -0.325 -0.198

-1.160 -0.817 -0.659 -0.352 -0.352 -0.247

-0.059 -0.119

-0.296

-0.171 -0.095

-0.232

-0.066 -0.054

-0.199

0.107 0.005

-0.155

perform stocks with large unfavorable announcement returns by 5.9 percent in the first six months, and by 8.3 percent in the first year. Tables III and IV both suggest that the underreaction to quarterly earnings surprises seems to be a more short-lived phenomenon than the underreaction to past returns.

The news reflected in the past earnings announcement return continues to leave its traces at the next announcement following portfolio formation (Panel D). The spread in returns between stocks that have delivered favorable surprises and those with unfavorable surprises is especially striking (8.8 percent). Market forecasts of earnings, as represented by SUE or analyst estimates, also respond slowly to the new information in announcement returns.

While behavioral or sociological considerations may impart a bias to analysts forecasts, an upward or downward revision in the consensus estimate may still convey information. Table V suggests that this is indeed the case. Moreover, of the three measures of earnings surprise, sorting stocks on REV6 yields the largest spread in one-year returns (9.7 percent).8 In other respects, the results in Table V are very similar to those for either standardized unexpected earnings or announcement returns.

To summarize, sorting stocks on the basis of past returns yields large differences in subsequent returns. Sorting on past earnings surprise (measured in a number of ways) also gives rise to large spreads in future returns. The spreads in returns associated with the earnings momentum strategies, however, tend to be smaller and persist for a shorter period of time when compared to the results of the price momentum strategy. Our evidence is consistent with the idea that the market does not incorporate the news in past prices or earnings promptly. Instead, the adjustment is gradual, so that there are drifts in subsequent returns. In the same manner, security analysts are slow to revise their expectations about earnings, particularly when the news in earnings is unfavorable. The asymmetry in the behavior of revisions with respect to past losers and past winners hints at the importance of the incentive structures analysts face when they issue forecasts.

8 We obtain similar results when we use monthly revisions in analyst forecasts instead of a six-month moving average. Womack (1996) also finds that changes in analyst buy or sell recommendations predict future returns.



Table IV

Mean Returns and Characteristics for Portfolios Classified by Abnormal Return Around Earnings Announcement

At the beginning of every month from January 1977 to January 1993, all stocks are ranked by their abnormal return around the most recent past announcement of quarterly earnings and assigned to one of ten portfolios. Abnormal returns are relative to the equally-weighted market index and are cumulated from two days before to one day after the date of earnings announcement. The assignment uses breakpoints based on New York Stock Exchange (NYSE) issues only. All stocks are equally-weighted in a portfolio. The sample includes all NYSE, American Stock Exchange (AMEX), and Nasdaq domestic primary issues with coverage on Center for Research in Security Prices (CRSP) and COMPUSTAT. Panel A reports the average past six-month return for each portfolio, and buy-and-hold returns over periods following portfolio formation (in the following six months and in the first, second, and third subsequent years). Panel В reports accounting characteristics for each portfolio: book value of common equity relative to market value, and cash flow (earnings plus depreciation) relative to market value. Panel С reports each portfolios most recent past and subsequent values of quarterly standardized unexpected earnings (the change in quarterly earnings per share from its value four quarters ago, divided by the standard deviation of unexpected earnings over the last eight quarters). Panel D reports abnormal returns around earnings announcement dates. In Panel E, averages of percentage revisions relative to the beginning-of-month stock price in monthly mean I/B/E/S estimates of current fiscal-year earnings per share are reported.

(Low)

(High)

Panel A: Returns

Past 6-month return

-0.026

0.039

0.061

0.074

0.085

0.099

0.113

0.132

0.161

0.223

Return 6 months after

0.063

0.077

0.088

0.093

0.094

0.099

0.099

0.101

0.111

0.122

portfolio formation

Return first year after

0.155

0.174

0.183

0.194

0.198

0.208

0.208

0.212

0.221

0.238

portfolio formation

Return second year after

0.186

0.190

0.185

0.192

0.197

0.198

0.199

0.196

0.205

0.207

portfolio formation

Return third year after

0.183

0.188

0.185

0.190

0.196

0.200

0.198

0.198

0.198

0.214

portfolio formation

Panel B: Characteristics

Book-to-market ratio

0.968

0.923

0.903

0.907

0.900

0.891

0.880

0.870

0.857

0.894

Cash flow-to-price ratio

0.119

0.140

0.146

0.150

0.148

0.149

0.148

0.146

0.139

0.122

Panel C: Standardized Unexpected Earnings

Most recent quarter

-0.485

-0.169

-0.005

0.126

0.191

0.273

0.329

0.364

0.465

0.508

Next quarter

-0.635

-0.186

-0.034

0.119

0.183

0.256

0.293

0.371

0.499

0.529

Panel D: Abnormal Return Around Earnings Announcements

Most recent

-0.076

-0.033

-0.020

-0.011

-0.004

0.004

0.011

0.021

0.035

0.089

announcement

First announcement after

-0.040

-0.017

-0.010

-0.006

-0.001

0.003

0.007

0.012

0.020

0.048

portfolio formation

Second announcement

-0.001

-0.002

0.000

0.001

0.002

0.002

0.003

0.003

0.004

0.007

after portfolio

formation

Third announcement

0.000

0.002

0.002

0.001

0.001

0.002

0.002

0.002

0.003

0.005

after portfolio

formation

Fourth announcement

0.001

0.001

0.000

0.002

0.000

0.002

0.001

0.002

0.003

0.001



Table IV-Continued

(Low)

2 3 4 5 6

10 (High)

Panel E: Revision in Analyst Forecasts (%)

Most recent revision Average over next 6

months Average from months 7

to 12

-1.135 -1.314

-1.215

-0.564 -0.372 -0.257 -0.261 -0.232 -0.514 -0.329 -0.284 -0.263 -0.223

-0.506 -0.363 -0.271 -0.307 -0.271

-0.273 -0.202

-0.280

-0.252 -0.234

-0.260

-0.338 -0.312

-0.275

-0.321 -0.319

-0.518

III. Price and Earnings Momentum: Multivariate Analysis

The evidence in the last section indicates that each of the momentum strategies that we consider is by itself useful in predicting future stock returns. We now examine whether the continuation in past price movements and the underreaction to earnings news are the same phenomenon.

A. Two-way Analysis of Price and Earnings Momentum

Our first set of tests addresses this issue in terms of a two-way classification. At the beginning of each month, we sort the securities in the sample on the basis of their past six-month returns and assign them to one of three equally-sized portfolios. Independently, we sort stocks and group them into three equally-sized portfolios on the basis of the most recent earnings surprise. Under this procedure each stock is assigned to one of nine portfolios. Table VI reports buy-and-hold returns over each of several periods following portfolio formation, as well as the average earnings surprise over the first subsequent year. Panel A reports the results when earnings surprises are measured as abnormal returns around earnings announcements, while Panels В and С provide results for standardized unexpected earnings and analyst revisions, respectively.

The first three panels in Table VI tell a consistent story. Most important, past realizations of six-month returns and earnings news predict continued drifts in returns in the subsequent period. In particular, the two-way sort generates large differences in returns between stocks that are jointly ranked highest and stocks jointly ranked lowest. For example, using past return in conjunction with earnings surprise measured as the abnormal announcement return, the highest-ranking portfolio outperforms the lowest-ranked portfolio by 7.9 percent in the first six months. Similarly, the six-month spread is 8.1 percent using prior return together with SUE, and 8.8 percent using prior return with analyst revisions.

Each variable (prior return or earnings surprise) contributes some incremental predictive power for future returns, given the other variable. In Panel A, holding prior return fixed, stocks with high past announcement return earn in the first six months following portfolio formation 2.8 percent more on



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