In his white paper "Overreacting to a History of Underreaction", Milian explores the possibility that well known cross sectional anomalies can reverse over time. Specifically, he investigates the reversal of the PEAD effect. He finds that contrary to previous research, stocks with the most negative previous earnings surprise actually exhibit the most positive returns following the subsequent earnings announcement.
This can be attributed to the idea that investors know they typically underreact to earnings announcement news (the underlying explanation for the PEAD). Thus, by compensating for their underreaction, they overreact to substantial surprises in earnings announcement news, positioning themselves in alignment with the expectation of the PEAD effect. When the next earnings announcement comes, the overcrowding of investors pushes the market beyond efficient, resulting in the correction of investor sentiment and a negative correlation for firm's earnings news in the following days.
Quantpedia summarizes the article's possible explanation for the PEAD reversal:
The paper speculates that it seems that due to their well-documented history of apparently underreacting to earnings news, investors are now overreacting to earnings announcement news. However classical PEAD (post-earnings announcement drift) literature examines mainly quarterly portfolio returns while this academic paper focuses on 2-days retun therefore it is probable that PEAD still holds and both anomalies exists concurrently.
OOS Study Results
I conducted a similar study examining the reversal in the PEAD, over a sample period from 2011 - 2016 (compared to the Milian's 2003 - 2010). Overall, I found my results to be consistent with Milian's results, when considering a hold period of 9 days following the Earnings Announcement, rather than 2.
I found that firms in the highest decile of past earnings surprise underperform stocks in the lowest decile by -1.78% over a hold period of 10 days (compared to -1.59% over a hold period of 3 days found in the paper).
Trading Strategy Details
1. Each day, pick stocks in the Q500US which have Earnings Announcements the next day
2. Go short on stocks in the highest decile of previous earnings surprise, long on stocks in the lowest decile of previous earnings surprise
3. Hold for a period of 10 days, then close the position
N.B.: As a result of parameter optimization, this strategy may be overfit.
Attached is the whitepaper walkthrough and OOS validation of the original study (Hit "Clone Notebook" to see a complete analysis). The backtest and backtest analysis are attached to the thread below.
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I can only run the backtest till 2014, why is that?