What Is Post Earnings Announcement Drift?
Post earnings announcement drift (PEAD) 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 after the initial earnings announcement. This phenomenon, categorized under behavioral finance and market anomalies, suggests that financial markets do not immediately and fully incorporate new information from earnings reports into stock prices. Instead, prices tend to "drift" gradually, often for several weeks or even months, following the positive or negative surprise. The existence of post earnings announcement drift challenges the notion of market efficiency, which posits that all publicly available information should be instantaneously reflected in asset prices.
History and Origin
The phenomenon of post earnings announcement drift was first extensively documented by academics 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 unexpected earnings for an extended period after the announcement. This initial finding was a significant challenge to conventional financial theory at the time. Subsequent research, notably by Victor Bernard and Jacob Thomas in 1989 and 1990, further confirmed the persistence of this drift, showing that it could last for several quarters and was particularly concentrated around subsequent earnings announcements. These early studies laid the groundwork for understanding this persistent market anomaly, suggesting that investors exhibited an underreaction to new information9, 10.
Key Takeaways
- Post earnings announcement drift (PEAD) is a market anomaly where stock prices continue to move in the direction of an earnings surprise for weeks or months after the announcement.
- It contradicts the strong form of the efficient market hypothesis, which suggests immediate price adjustment to new information.
- The drift is often attributed to investor behavior and cognitive biases, such as conservatism or delayed processing of information.
- PEAD has historically presented potential opportunities for active traders and investors, though its magnitude may have attenuated over time.8
- The effect is generally observed with both positive and negative earnings surprises, leading to upward or downward price drifts, respectively.
Interpreting the Post Earnings Announcement Drift
Interpreting post earnings announcement drift involves recognizing that the market's initial reaction to an earnings surprise may be incomplete. When a company announces earnings that significantly beat or miss analyst expectations, the stock price often makes an initial jump or drop. However, PEAD suggests that this initial adjustment is insufficient, and the market continues to slowly process the full implications of the news. For investors, a positive drift indicates that the market is gradually adjusting upward as more participants recognize the underlying strength implied by the earnings, while a negative drift points to continued downward revision of expectations. This slow adjustment is thought to stem from factors such as information asymmetry or various forms of market psychology.
Hypothetical Example
Consider "Tech Innovations Inc." (TII), a publicly traded company. On January 15th, TII announces its fourth-quarter earnings, reporting earnings per share (EPS) of $1.50 against analyst expectations of $1.20. This constitutes a significant positive earnings surprise. On the announcement day, TII's stock price jumps from $50 to $53.
According to the concept of post earnings announcement drift, this might not be the end of the positive price movement. Over the subsequent weeks, as more investors and analysts fully digest the implications of TII's strong performance, the stock price continues to gradually climb. By mid-March, before the next earnings announcement, TII's stock price has drifted further upward to $57, representing a total appreciation of $7 from its pre-announcement price. This sustained upward movement after the initial jump is an example of positive post earnings announcement drift, illustrating how the market takes time to incorporate all relevant financial information.
Practical Applications
Post earnings announcement drift has practical implications primarily for event-driven investment strategies and in the realm of fundamental analysis. Investors and traders often seek to capitalize on this anomaly by identifying companies with significant earnings surprises. Strategies typically involve taking long positions in stocks that report surprisingly good news and short positions in those with unexpectedly poor results. This approach aims to profit from the anticipated continuation of the price movement in the direction of the surprise over the subsequent weeks or months7.
Academic research continues to investigate the nuances of PEAD. Recent studies, including experimental evidence, confirm the existence and economic significance of post earnings announcement drift, noting that while its magnitude might vary, it remains a persistent phenomenon in financial markets6. Understanding this drift can also inform how analysts refine their expectations following financial reporting.
Limitations and Criticisms
Despite its long-standing presence as a recognized market anomaly, post earnings announcement drift faces several limitations and criticisms. One primary challenge is the debate surrounding its underlying causes; while many attribute it to investor underreaction or other behavioral biases, some argue that it could be explained by uncaptured risk-adjusted return premiums or methodological shortcomings in studies5. The profitability of trading strategies based on PEAD may also be diminished by transaction costs and the challenges of accurately measuring and isolating the drift from other market factors4.
Furthermore, some research suggests that the magnitude of PEAD has declined over time in developed markets, possibly due to increased market efficiency and the increased focus of institutional investors on exploiting such anomalies. Empirical studies have also explored whether naive individual investor behavior drives the drift, with some evidence suggesting that individual investor trading does not fully explain the phenomenon3.
Post Earnings Announcement Drift vs. Efficient Market Hypothesis
Post earnings announcement drift (PEAD) stands in direct contrast to the efficient market hypothesis (EMH). The EMH postulates that all available information is immediately and fully reflected in a security's price, implying that it is impossible to consistently earn abnormal returns using public information. In this view, an earnings surprise should cause an instant and complete adjustment of the stock price, leaving no room for subsequent predictable drift.
However, PEAD suggests that prices adjust slowly, implying a degree of market inefficiency. While the EMH assumes rational market participants who process information instantly, PEAD often attributes the delayed reaction to behavioral biases, such as investor psychology, limited attention, or cognitive conservatism, where investors are slow to update their beliefs based on new information. This fundamental difference in how information is incorporated into prices is what makes PEAD a classic challenge to the EMH.
FAQs
What causes post earnings announcement drift?
The most widely accepted explanation for post earnings announcement drift is the market's underreaction to new information contained in earnings announcements. This slow processing can be due to various behavioral biases among investors, such as conservatism (slow to update beliefs) or limited attention, which prevents prices from adjusting instantly and fully.
Is post earnings announcement drift still relevant today?
While some studies suggest the magnitude of post earnings announcement drift may have attenuated in highly developed markets due to increased market efficiency and the proliferation of quantitative trading strategies, recent academic research continues to find evidence of its existence and economic significance.2
How long does post earnings announcement drift typically last?
Post earnings announcement drift can last for several weeks or even several months following the initial earnings announcement. Some studies indicate that a significant portion of the drift can occur over the subsequent 60 to 90 trading days, with effects sometimes observed up to the next few quarterly earnings reports.
Can investors profit from post earnings announcement drift?
The existence of post earnings announcement drift suggests potential profit opportunities for investors who can identify significant earnings surprise and take positions in anticipation of the continued price movement. However, implementing such strategies successfully requires careful fundamental analysis, managing transaction costs, and understanding the risks associated with market timing and potential price reversals.1