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FearandGreedJPM0922 PDF
FearandGreedJPM0922 PDF
Announcements
Summer, 2016
Abstract: This study documents that earnings announcements serve as a reality check on short-
term, fear and greed driven price development: stocks with extreme abnormal returns in the week
before an earnings announcement experience strong price reversal around the announcement. A
trading strategy that exploits this reversal is profitable in 40 of the last 42 years and earns
abnormal returns in excess of 1.3% over a two day-window.
___________________
We thank an anonymous referee, Brandon Cline, Lee Sanning, and Uzi Yaari for helpful comments and
suggestions.
“Be fearful when others are greedy and greedy when others are fearful” — Warren Buffett
Fear and greed are deeply ingrained in life, and are fundamental attributes to the survival
of man. Without the right dose of fear, we would expose ourselves to unreasonable threats, and
without the right dose of greed, we would forego opportunities to secure the resources that we
need to live. However, too much of either fear or greed is often harmful. An individual overcome
by fear, for example, will not be able to pursue opportunities that will help him secure the
resources he needs; and an individual overcome by greed will not recognize and avoid the threats
to his existence. In other words, for optimum survival, fear and greed need to be “balanced.”
In financial markets, where prices are set by the interactions of thousands of individuals,
“greed” for profits and “fear” of losses drive investors to make value assessments as carefully as
possible, thus contributing to market efficiency. But, in this setting also, excessive or unbalanced
fear or greed can be harmful. Warren Buffett’s quote above succinctly speaks to the dual nature
of fear and greed in investing. In a market with too many greedy or fearful investors, aggressive
buying or selling may cause an overreaction, at which point it is profitable to take a contrarian
position. Many investors understand this, and the history of markets has countless examples of
asset prices becoming irrationally high or low because of greed and fear. The challenge in trying
to profit from this mispricing, of course, lies in timing. That is, it is unclear when the market will
“come to its senses” and prices will revert to levels justified by fundamentals. It is difficult,
1
Buffett’s advice is clearly intended as an investment strategy for the long-term; not the short-term. However, the
reality is that most investors face powerful short-term performance pressures. For example, Stan Druckenmiller, the
lead money manager at George Soros’ Quantum Fund, closed all of his long positions in dot-com stocks in February
of 2000 based on the (correct) belief that dot-com prices reflected a bubble. Weeks later, however, after prices had
continued their run-up and his performance was significantly lagging that of his colleagues, Druckenmiller
reclaimed those long positions. A few weeks later, the bubble burst.
1
In this study, we develop a trading strategy around earnings announcements that seeks to
profit from predictable reversals of fear and greed driven price development in individual stocks.
We argue that earnings announcements are logical events around which to center such a trading
strategy, because they convey fundamental information about asset prices and thus have the
asymmetry in the period just before an earnings announcement, price development is probably
particularly susceptible to excessive fear or greed. That is, if uninformed investors observe sharp
price changes just before an earnings announcement, they may attribute these to the informed
trading of insiders; start to excessively trade in the same direction themselves; and thus cause an
overreaction. We therefore predict—in the spirit of Warren Buffett’s advice—that stocks that
experience sharp price changes just before an earnings announcement will experience price
reversal at the time of the announcement itself. We test this prediction with a trading strategy
that on the earnings announcement date takes (1) a long position in stocks that experienced
extreme negative abnormal returns in the week prior, and (2) a short position in stocks that
We find that, over the two day window of the earnings announcement date and the day
following, both positions are highly profitable. On average, the long position earns abnormal
returns of 1.49%, and the short position earns 1.20%. We furthermore show that these return
reversals are about 60% larger than around non-earnings announcement dates, and thus are
significantly more pronounced than short-term return reversals documented in the prior literature
(e.g., Lehmann [1990] and Figelman [2007]). We also show that our strategy (1) is profitable in
40 of the 42 years in our sample; (2) is similarly profitable in “bear” and “bull” markets; (3) and
is significantly profitable for both large firms and high volume stocks. Since the year 2000—
2
using a conservative transactions costs estimate of 70 basis points for a round trip trade—we find
that our strategy generates abnormal returns of 0.76% after transaction costs, or 95% on an
annualized basis. We conclude, therefore, that prices are subject to sentiment-driven price
announcements, and that the announcements themselves serve as a reality check on that price
development.
The history of financial markets has countless examples of asset prices rising or falling
rapidly, and then suddenly reversing. This has been true for individual securities, certain
industries, and entire asset classes. Unbalanced fear or greed in financial markets most
commonly manifests itself as price momentum; which according to Fama [1998] is one of the
two most robust and persistent anomalies posing a challenge to the efficient market paradigm. 2
While price momentum is usually argued to have its source in underreaction (Jegadeesh and
Titman [1993]), it often ultimately produces an overreaction (Lehmann [1990], Hong and Stein
[1999], Hirschey [2003], and Figelman [2007]). This could be an overreaction to underlying
fundamentals—for example, Zarowin [1989] documents that firms with a string of good (bad)
price/investor behavior—for example, the indiscriminate selling of stocks in the wake of the
financial crisis in 2008. Also, the price momentum can occur over a period of months (e.g.,
Jegadeesh and Titman [1993]), or within a single day (e.g. Fabozzi, Ma, Chittenden, and Pace
[1995], Schulmeister [2009]). The defining feature of unbalanced fear and greed driven price
2
The other one is post-earnings announcement drift: the tendency of stock prices to drift upward (downward) after
surprisingly good (bad) earnings news.
3
momentum, however, is the reversal that occurs afterwards. This price reversal thus offers an
investment opportunity for contrarian investors, as captured in Warren Buffett’s advice to “be
fearful when others are greedy and greedy when others are fearful.” However, timing a price
reversal is very difficult, and potentially very costly, even when an investor is correct in his or
her assessment of mispricing. Theoretical papers indeed demonstrate that, even when rational
investors are aware of mispricing in the market and take positions to exploit it, the mispricing
can persist and may, in fact, get worse (De Long, Shleifer, Summers, and Waldmann [1990], and
In this study, we argue that earnings announcements are natural candidates for the
implementation of a contrarian trading strategy that seeks to exploit the reversal of fear/greed
driven price momentum. First, the increase in information asymmetry preceding the earnings
announcement makes it more likely that excessive sentiment affects pricing during that time.
check on that sentiment, making it more likely that price reversal will occur (if there is indeed
mispricing). 4 Third, the earnings announcement date is known ex ante, which makes it possible
to anticipate the price reversal and thus implement a trading strategy. These last two arguments
being taken advantage of by informed traders. Market makers, for example, protect themselves
by increasing bid-ask spreads and reducing depths in the period before the earnings
3
An instructive example is the case of Long-Term Capital Management’s bet on the convergence of Royal Dutch
Petroleum and Shell Transport. These two companies co-own Royal Dutch/Shell and receive their income from the
same sources. There is no theoretical justification, in other words, for their prices to diverge. LTCM took a position
to exploit this mispricing when the divergence was 8%, but was later forced to liquidate the position when
divergence had increased to 22% (Lamont and Thaler 2003).
4
Many studies in accounting research indeed document that, at the time of an earnings announcement, stock prices
move in the same direction as the earnings surprise (e.g., Wilson [1987], Collins and Kothari [1989]).
4
announcement (Lee, Mucklow and Ready [1993]). Because there is usually very little public
information about a stock in the week before an earnings announcement, large price movements
are more likely attributable to the trading activities of investors with private information.
Individual investors—who tend to watch their portfolios very closely and “over” trade in them
(Barber and Odean [2001], [2002a], and [2002b])—are probably particularly sensitive to the
particular, may respond to large price movements at this time by trading in the same direction,
thus contributing to price momentum. Specifically, we argue that when individual investors
observe a large price increase, they may infer that insiders know that the upcoming earnings
announcement will reveal unexpectedly good news. Greedy to profit from this inference, the
individual investor will “jump on board” and push the price up even further. Similarly, when
individual investors observe a large price decrease, they may infer that insiders know that the
upcoming announcement will reveal unexpectedly bad news. Fearful to suffer the corresponding
losses, the individual investor will “jump ship” and push the price down even further. We argue
that the resulting sentiment-driven price momentum will result in an overreaction; thus setting
We implement our strategy as follows. We first select stocks with extreme abnormal
returns in the week before the earnings announcement (from day -5 to -1, relative to the
announcement date reported on Compustat). We use three different benchmarks for extreme
abnormal returns during this window: 5%, 10% and 15%. Note that we do not argue that all
stocks in our trading strategy have experienced sentiment driven price momentum in the pre-
announcement window. We simply rely on the argument that, among the stocks with large price
5
increases, there are some that experienced greed driven price momentum such that, on average,
stocks with large price increases are overpriced; and vice versa. Then, on the day of the earnings
announcement, we take a long position in stocks that experienced extreme negative abnormal
returns, and a short position in stocks that experienced extreme positive abnormal returns. We
continue to hold both positions until the next day, to capture the abnormal returns for those
contemporaneous return from the portfolio of firms in the same size-decile. We use size-adjusted
abnormal returns because firm size is often found to be a significant determinant of the
profitability of trading strategies and the magnitude of anomalies. In sensitivity analyses, we also
examined abnormal returns estimated relative to the market model, and to the three-factor Fama-
French [1993] model. The results from those analyses are qualitatively similar to those reported
in this study.
Compustat, starting in the second half of 1971 and ending in 2012. We obtain volume, price and
firm size information from CRSP. We focus only on common shares and eliminate all
observations with missing data, as well as those securities that are traded on exchanges other
than the NYSE, AMEX or NASDAQ. Because of restrictions that brokers impose on trading
low-priced stocks (e.g., inability to sell them short or buy on margin) we eliminate all stocks
with prices less than $2 per share. Our total sample consists of 643,669 observations.
6
Trading Strategy Abnormal Returns
Exhibit 1 reports the abnormal returns from our trading strategy. The results are reported
in three panels, corresponding to the three abnormal returns benchmarks we use during our
screen window: 5%, 10% and 15%. The results in all three panels confirm the economic and
statistical significance (p-value<0.0001 in all cases) of the profitability of our trading strategy.
For brevity, we focus our discussion on the results in panel B, where we screen for firms with
abnormal returns in excess of ±10% in the week before the earnings announcement.
There are 25,226 observations (about 3.9% of the total) that experience abnormal returns
below negative 10%, and 37,568 observations (about 5.8% of the total) that experience abnormal
returns above positive 10%. During the (-5,-1) screen window, these stocks have average BHAR
of –15.01% and 18.08%, respectively. Consistent with our argument that this reflects, on
average, at least some overreaction, the stocks indeed experience very significant return reversals
In the subsequent (0,1) holding window. And so the long position in our trading strategy
generates a profit of 1.49%, while the short position generates a profit of 1.20%. A weighted
average between the two positions equals 1.32% which, on an annualized basis, translates into
Panels A and C further show that the profitability of our trading strategy is increasing in
the magnitude of the abnormal returns benchmark during the screen window. The abnormal
returns for the long positions increase from 0.80% in Panel A, to 1.49% in Panel B, reaching
2.26% in Panel C. The abnormal returns for the short positions similarly increase across the three
5
We annualize abnormal returns by multiplying the two-day holding window return by 126, because a typical year
has 126 such windows (i.e., 252 trading days).
7
Trading Strategy Abnormal Returns over Time
To investigate whether our trading strategy profits are driven by just a few stellar years,
we calculate the average holding window abnormal returns for each year in our sample for the
stocks that experienced at least ±10% abnormal returns during the screen window (cf., Panel B in
Exhibit 1). The results are reported in Exhibit 2. They show that the long and short positions are
profitable in 40 and 38 years, respectively, of the 42 years in our sample period. Moreover, the
weighted average of the two legs of the strategy is profitable in 40 of the 42 years.
While the preceding results suggest that the trading strategy is profitable in both bull and
bear markets, we explicitly investigate its profitability as a function of market sentiment in panel
A of Exhibit 3.6 This investigation is relevant not only because many anomalies show different
returns depending on market sentiment, but our study is a specific investigation of sentiment-
driven price development. We find that the long position generates slightly higher profits in bull
markets (1.63% versus 1.12%), but that the short position generates slightly higher profits in bear
markets (1.63% versus 1.08%). A weighted average abnormal return between the long and short
positions (not reported) shows that the trading strategy’s profitability is actually a little bit higher
in bear than in bull markets (1.40% versus 1.29%). This finding compares very favorably with
the profitability of most well-known trading strategies, which earn positive returns in bull
To address the concern that our strategy’s returns might be driven by small and/or illiquid
firms, we investigate the profitability of our trading strategy after partitioning the sample into
6
We define bull and bear markets consistent with J.P. Morgan Asset Management.
https://www.jpmorgan.com/cm/BlobServer/Guide_to_the_Markets_4Q_2011.pdf
8
size terciles and dollar-volume terciles. We do so, once again, after limiting our investigation to
those stocks that experienced at least ±10% abnormal returns during the screen window.
Panel B of Exhibit 3 presents the results of our trading strategy for size terciles based on
NYSE breakpoints. Small firms indeed generate the highest holding period returns, but the
returns for medium and large firms are also statistically and economically significant. For
example, the long position for large firms generates a profit of 1.40%, while the short position
earns a profit of -0.48% over two days. Thus, Panel B shows that the trading strategy profits are
Panel C of Exhibit 3 presents the results of our trading strategy across dollar-volume
terciles. To create these terciles, we first divided our original sample into three equal sized
dollar-volume portfolios based on total dollar volume during the holding window, after which we
identified stocks which experienced at least ±10% abnormal returns during the screen window.
Not surprisingly, the least liquid stocks experience the greatest return reversals during the
holding window; but, once again, even for the most liquid stocks, our trading strategy is highly
profitable, generating a 1.31% profit in the long, and a 0.4% profit in the short position. Thus,
The consistent profitability of our trading strategy over the last four decades clearly
suggests that fear and greed affects pricing in the week preceding earnings announcements. To
on the strategy’s profitability since 2000. Estimates of transaction costs vary across sources. For
7
Recall that we eliminate all stocks with prices less than $2 from our analyses. Transaction costs (as well as returns)
are often particularly high for small priced stocks. Those stocks, however, are not included in this study.
9
example, Stoll [2006] estimates transaction costs in 2001 at 28 basis points for a roundtrip trade.
Elkins McSherry, a global expert in trade cost analysis, estimates the average costs in 2007 at 66
basis points and in 2009-2011 at 53 basis points (Pollin and Heintz [2011]). Finally, ITG Global
Cost Review estimates transaction costs to range from 43 to 55 basis points between 2009 and
2013. Compared to these numbers, we use a relatively conservative estimate of transaction costs
of 70 basis points for a roundtrip trade to assess the implementability of our trading strategy.
From 2000 through 2012, the net profit of our strategy—i.e., after subtracting transaction
costs of 0.7%—is 0.49% for the long position and 0.96% for the short position. These abnormal
returns are statistically significant at the 0.0001 level. Moreover, the annualized abnormal returns
would range from 60% for the long to more than 120% for the short position. Based on a
weighted average between the long and short positions, the strategy would (1) generate a net
profit of 0.76% from 2000 through 2012, for an annualized return of 95%, and (2) be profitable
We discuss the results of several additional robustness tests in this section. They are not
tabulated here, but are available online. First, we investigate whether our results are different
from the generic, weekly return reversal patterns documented in Lehman (1990). To this end, we
estimate return reversals from implementing our trading strategy around five, equally spaced,
non-earnings announcement dates in the same fiscal quarter: 2, 4, 6, 8 and 10 weeks before the
actual earnings announcement. Our results show that the return reversal around the actual
earnings announcement date is about 60% higher than around non-earnings announcement dates.
10
Second, we document the robustness of our trading strategy returns to alternative screen
and holding windows. We find that the trading strategy becomes slightly more profitable when
extending the holding window up to day +5. However, we also find that further extending the
holding window to day +10, decreases profitability. When we extend the screen window to start
on day -7, -10 or -20, instead of on day -5, we find that the trading strategy becomes less
profitable the further we extend the screen window. Finally, we shift both the screen and holding
windows, by “moving” day -1 from the former to the latter. We do so to allow for the possibility
that inside information leakage on the day immediately before the earnings announcement
already causes return reversal at that time. The results indicate that this is the case. Using a
(-5,-2) screen, and a (-1,1) holding window, significantly increases the strategy’s profitability:
from 1.49% to 2.36% for the long, and from 1.20% to 1.59% for the short position. 8 Moreover,
based on these windows, both legs of the trading strategy are profitable in each of the last 42
years. This is a remarkable finding that first of all speaks to the statistical significance of the
trading strategy’s profitability, but especially speaks to its economic significance. To our
announcement drift—that has been consistently profitable for such a long time.
CONCLUSION
This study documents that a contrarian trading strategy around earnings announcements,
in stocks that experienced extreme abnormal returns in the week preceding the announcements,
in stock prices in the pre-announcement period. Specifically, we argue that due to heightened
information asymmetry just before earnings are announced, individual investors in particular
8
A further shift to include day -2 in the holding window as well, leads to a significant decline in the strategy’s
profitability.
11
trade in the direction of observed price changes, contributing to price-momentum that ultimately
results in overreaction. Then, when the earnings are announced and information asymmetry is
reduced, the overreaction leads to price reversal. We find that our trading strategy generates
abnormal returns of 1.3% over a two-day window, which is more than 160% on an annualized
basis. After transaction costs, and since the year 2000, the annualized abnormal returns equal
95%. We also document that our trading strategy is similarly profitable in bull and bear markets,
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EXHIBIT 1. Trading Strategy Abnormal Returns.
This exhibit reports buy-and-hold, size-adjusted abnormal returns. The screen window runs from day -5
through day -1, relative to the earnings announcement. The holding window runs from day 0 through day +1.
Stocks with prices less than $2. All reported returns in this exhibit are significant at the 0.0001 level.
4.0%
2.0%
Short
0.0% Long
-2.0%
-4.0%
1971 1976 1981 1986 1991 1996 2001 2006 2011
14
EXHIBIT 3. Robustness of the Trading Strategy Abnormal Returns
This exhibit reports buy-and-hold, size-adjusted abnormal returns over a (0,+1) holding window relative to the earnings announcement. The stocks in this
exhibit experienced screen window abnormal returns in excess of 10% positive/negative (cf., Panel B in Exhibit 1). In Panel A, we assess the robustness
of the trading strategy abnormal returns to periods of bull versus bear markets. We define bear markets consistent with J.P. Morgan Asset Management.
They identify the following bear markets during our sample period: January 5, 1973 – October 3, 1974; November 28, 1980 – August 12, 1982; August
25, 1987 – December 4, 1987; March 24, 2000 – October 9, 2002; and October 9, 2007 – March 9, 2009. All other dates are bull markets. In Panel B, we
assess the robustness of the trading strategy abnormal returns to firm size. Stocks are assigned, by year, to three size portfolios, where the portfolio
cutoffs correspond to the 33rd percentile and 67th percentile of NYSE market-caps. Finally, in Panel C, we assess the robustness of the trading strategy
abnormal returns to liquidity, as measured by $-trading volume. Stocks are assigned, by year, to three equal-sized $-Volume portfolios, based on total
dollar volume during the holding window. Stocks with prices less than $2 are deleted. All reported returns in this exhibit are significant at the 0.0001
level, except for the -0.48% in Panel B, which is significant at the 0.003 level.
Panel A: Robustness of Trading Strategy Abnormal Returns to Bull and Bear Markets
15