What Is Absolute Earnings Drift?
Absolute earnings drift refers to the observed tendency for a company's stock price to continue moving in the direction of an earnings surprise for an extended period following an earnings announcement. This phenomenon is considered a significant market anomaly within the field of Behavioral Finance, as it challenges the traditional notion of market efficiency. Instead of prices immediately and fully reflecting new information, they "drift" over several weeks or even months. This gradual adjustment suggests that investors do not instantly incorporate all publicly available earnings information into their valuation models.
History and Origin
The concept of earnings drift, specifically known as Post-Earnings-Announcement Drift (PEAD), was first rigorously documented by Ray Ball and Philip Brown in their seminal 1968 study, "An Empirical Evaluation of Accounting Income Numbers." Their research revealed that, contrary to the tenets of the efficient market hypothesis, stock prices continued to drift in the direction of an earnings surprise for an extended period after the announcement date13, 14. This finding marked a pivotal moment in financial research, suggesting that new information, particularly earnings, was not as rapidly incorporated into prices as previously assumed. The persistence of this anomaly over decades has made it one of the most well-known and studied phenomena in financial economics. A detailed overview of its history and research evolution can be found in academic literature discussing decades of PEAD research.12
Key Takeaways
- Absolute earnings drift describes the phenomenon where stock prices continue to adjust gradually after a company announces its earnings, moving in the same direction as the initial earnings surprise.
- It is considered a market anomaly, suggesting that markets are not perfectly efficient in instantly processing all new information.
- This drift is often attributed to the slow processing of information by investors or other market frictions, falling under the umbrella of behavioral finance.
- The phenomenon implies that it might be possible for certain trading strategies to generate abnormal returns by exploiting this delayed reaction.
- While well-documented, the magnitude of the absolute earnings drift has shown signs of declining in developed markets over time, possibly due to increased investor awareness and improved information processing.
Formula and Calculation
The absolute earnings drift itself isn't a single calculated value but rather the observed price movement. However, to identify the surprise component that drives the drift, the concept of Standardized Unexpected Earnings (SUE) is often used. SUE quantifies the magnitude of the earnings surprise.
The formula for Standardized Unexpected Earnings (SUE) is:
Where:
- (Actual~EPS) = The company's reported earnings per share.
- (Expected~EPS) = The consensus earnings per share forecast from financial analysts.
- (Standard
Deviationof~Forecasts) = A measure of the dispersion or uncertainty among analyst forecasts for the earnings per share.
A positive SUE indicates a positive earnings surprise, meaning actual earnings exceeded expectations, while a negative SUE indicates a negative surprise. This value helps in identifying firms likely to experience absolute earnings drift.
Interpreting the Absolute Earnings Drift
Interpreting the absolute earnings drift involves observing the post-announcement trajectory of a stock's price relative to the initial earnings surprise. If a company reports significantly better-than-expected earnings (a positive surprise), the stock price tends to initially jump, but then continues to climb gradually over subsequent weeks or months. Conversely, if earnings fall significantly short of expectations (a negative surprise), the stock price often drops initially and then continues its downward trajectory.
This sustained movement, the absolute earnings drift, suggests that the market's initial reaction, while directionally correct, is often incomplete. Investors may "underreact" to the full implications of the earnings news for future profitability and value. The presence of this drift challenges the notion of perfectly efficient financial markets, implying that market participants may suffer from various cognitive biases that lead to delayed processing of information. Understanding this drift can provide insights into how information flows are digested by the market and impact investor behavior.
Hypothetical Example
Consider Tech Innovations Inc. On January 15th, they announce quarterly earnings of $1.20 per share, significantly higher than the analyst consensus estimate of $0.90 per share. This represents a strong positive earnings surprise.
On the announcement day, Tech Innovations' stock price jumps 8% from $50 to $54. A perfectly efficient market hypothesis would suggest that all the information from this earnings surprise is immediately priced in. However, due to absolute earnings drift, the stock continues to climb. Over the next three months, even without further significant news, the stock price gradually ascends, reaching $58 by April 15th. This sustained increase of $4 (or approximately 7.4% from the post-announcement price) demonstrates the absolute earnings drift, where the market continues to incorporate the positive earnings news over time, rather than instantly. This gradual adjustment could be due to factors like some investors taking longer to process the information or a slow unwinding of short positions.
Practical Applications
The absolute earnings drift has several practical implications for investors and market participants. Since the drift implies a predictable, albeit slow, movement in stock prices following an earnings surprise, it has been explored as a basis for various trading strategies. Investors might attempt to capitalize on this phenomenon by buying stocks that have just reported positive earnings surprises and selling or shorting those with negative surprises, holding them for a period until the drift is expected to subside. For instance, recent earnings seasons often feature companies that beat analyst expectations, leading to subsequent price appreciation, as reported by financial news outlets.11
Furthermore, the existence of absolute earnings drift underscores the relevance of behavioral finance in understanding market dynamics. It highlights that human psychological factors, such as underreaction to new information, can lead to deviations from theoretical market efficiency. Recognizing this can help investors temper their expectations about immediate price reactions and instead focus on longer-term trends influenced by fundamental data. For financial professionals, understanding this anomaly informs risk management and portfolio construction, acknowledging that not all information is processed instantaneously.
Limitations and Criticisms
Despite being a well-documented market anomaly, absolute earnings drift faces several limitations and criticisms. A primary critique stems from its apparent contradiction with the efficient market hypothesis, which posits that all available information is immediately reflected in stock prices. Proponents of market efficiency often argue that the observed drift is merely a manifestation of unidentified risk factors not captured by standard asset pricing models, often referred to as a "bad-model problem."10
Moreover, the magnitude of the absolute earnings drift has been observed to decline over time, particularly in more developed financial markets9. This reduction could be attributed to increased academic research making the anomaly widely known, leading more investors to try and exploit it. As more participants attempt to profit from the drift, the arbitrage opportunities tend to diminish. Some studies also suggest that the drift might be an artifact of aggregation bias in portfolio analysis, questioning whether it truly persists at the individual firm level.8 While behavioral explanations involving delayed investor information processing are common6, 7, the precise psychological mechanisms and their consistent impact remain subjects of ongoing debate within behavioral finance. Critics of the efficient market hypothesis and related anomalies are explored in depth by the American Economic Association.5
Absolute Earnings Drift vs. Post-Earnings-Announcement Drift
The terms "Absolute Earnings Drift" and "Post-Earnings-Announcement Drift" ([RELATED_TERM]) are often used interchangeably, referring to the same phenomenon. The latter, Post-Earnings-Announcement Drift (PEAD), is the more formal and widely recognized academic term in financial economics and accounting research. Both terms describe the tendency for a stock's cumulative abnormal returns to drift in the direction of an earnings surprise for a period following the company's earnings announcement3, 4.
The core idea is the delayed or incomplete adjustment of stock prices to new earnings information. Whether referred to as absolute earnings drift or PEAD, the implication is that markets do not immediately and fully incorporate all available information, presenting a challenge to strong forms of the efficient market hypothesis. The choice of term often comes down to specific academic or industry conventions, but their meaning is essentially identical.
FAQs
What causes absolute earnings drift?
Absolute earnings drift is generally attributed to market participants' slow reaction or "underreaction" to new information contained in earnings announcements. This can stem from various behavioral biases, where investors may not fully appreciate the implications of current earnings for future company performance, leading to a gradual rather than instantaneous price adjustment. It also challenges the idea of perfect market efficiency.
Can investors profit from absolute earnings drift?
Historically, academic research has suggested that trading strategies designed to exploit absolute earnings drift (or PEAD) by buying stocks with positive earnings surprises and selling those with negative surprises could generate abnormal returns. However, as this anomaly has become more widely known, its magnitude may have diminished, and transaction costs can significantly impact profitability.
Is absolute earnings drift consistent with the efficient market hypothesis?
No, the existence of absolute earnings drift is widely considered a contradiction to the strong and semi-strong forms of the efficient market hypothesis. The hypothesis states that all publicly available information (semi-strong form) or even private information (strong form) is immediately and fully reflected in stock prices. The drift implies a delayed reaction, indicating market inefficiency.
How long does absolute earnings drift typically last?
Studies on absolute earnings drift have shown that the price drift can persist for several weeks or even several months (e.g., up to 60 days or 13 weeks) following the initial earnings announcement1, 2. The exact duration can vary depending on market conditions, the liquidity of the stock, and the magnitude of the initial earnings surprise.
Does absolute earnings drift apply to all types of stocks?
While absolute earnings drift has been observed across various types of stocks, its magnitude can differ. Some research suggests it might be more pronounced in smaller, less-followed companies where information dissemination and processing might be slower. The phenomenon is a broad market observation within behavioral finance, but individual stock characteristics can influence its specific manifestation.