Can Post-Earnings Announcement Drift and Momentum Explain Reversal?

We study the interrelation among the post-earnings announcement drift (PEAD) and momentum short-term anomalies, and the reversal long-term anomaly. Some theories argue that PEAD and momentum are a consequence of underreaction to new information on the market. One theory in particular, suggests that this underreaction occurs because investors are unsure about their interpretations of the impact of new information on the fundamental price, and look for the market consensus interpretation for guidance. This learning process takes time, and until it is complete, prices do not fully incorporate the new information. Furthermore, the more difficult it is to interpret the new information, the more prices underreact to the new information arrival, and the longer it takes for them to fully incorporate this information. On the other hand, there are investors that rely too much on past performance (known as “trend chasers”). These investors, motivated by the short-term performance during the underreaction period, push prices beyond their fundamentals, resulting in an overreaction whose correction generates long-run reversal. And the more difficult it is to interpret new information, the more likely it is that trend chasers create overreaction, leading to stronger reversals in the future. Therefore, uncertainty about the interpretation of new information can potentially link today’s reversal to past momentum and PEAD. Our major goal is to test this hypothesis. For that, we use a multifactor risk-based model and NYSE-AMEX stock prices for the period starting at January 1975 to December 2010. Our main conclusion points for a statistical and economical relation between past PEAD and reversal. The higher the returns of the PEAD zero-investment portfolio two years ago, the higher the returns of the reversal zero-investment portfolio today.