Scholars’ Research Identifies New Returns-Based Trading Strategy

A surprising trend toward fear and greed identified by two faculty members in the Rutgers School of Business–Camden led to a published paper this summer and a subsequent article in The Wall Street Journal.

The researchers, Ivo Jansen, an associate professor of accounting, and Andrei Nikiforov, an assistant professor of finance, did not start out specifically looking at the impact of earnings reports on returns, which is the topic of their article, titled “Fear and Greed: A Returns-Based Trading Strategy Around Earnings Announcements,” in the summer 2016 issue of the Journal of Portfolio Management. Instead, the faculty members were collaborating on a broader research project on financial markets when they noticed a trend in the data.

Jansen was reminded of a professor he had in graduate school who gave his students this advice on their research endeavors: “If you are digging for gold, but you happen to find diamonds or silver, don’t ignore them.”

In their unexpected study, the professors found that “earnings announcements serve as a reality check on short-term, fear- and greed-driven price development. Stocks with extreme abnormal return in the week before an earnings announcement experience strong price reversal around the announcement.”

The Wall Street Journal featured the researchers in an article headlined “A Market-Timing Strategy That Just Might Work” in a Sept. 22, 2016, article written by Steven Russolillo.

In looking at data from 1971 to 2012, Jansen and Nikiforov focused on common shares and eliminated observations with missing data, as well as those securities that are traded on exchanges other than the NYSE, AMEX or NASDAQ. Based on restrictions that brokers impose on trading low-priced stocks, the researchers eliminated all stocks with prices less than $2 per share. Their total sample consisted of 643,669 observations.

The Rutgers University–Camden financial researchers found that “a contrarian trading strategy around earnings announcements, in stocks that experienced extreme abnormal return in the week preceding the announcements, is highly profitable.” Jansen and Nikiforov attribute the significant price reversal to a sentiment-driven overreaction in stock prices in the pre-announcement period.

The most plausible explanation, Nikiforov says, is that just before earnings are announced, investors unconnected to the company are overly attentive to stock changes – perhaps based on a fear of insider trading leaks – and give any changes in buying or selling irrational weight. This contributes to the “price-momentum that ultimately results in overreaction,” the researchers wrote. “Then, when the earnings are announced and information asymmetry is reduced, the overreaction leads to price reversal.”

The faculty members found that their trading strategy “generates abnormal returns of 1.3 percent over a two-day window, which is more than 160 percent on an annualized basis. After transaction costs, and since the year 2000, the annualized abnormal returns equal 95 percent.”

This trading strategy, according to the researchers, is “similarly profitable in bull and bear markets, and is robust to firm size and liquidity.”

Jansen teaches financial accounting in the undergraduate, MBA, and professional graduate programs at Rutgers–Camden. His research interests include financial statement analysis, valuations, earnings management, mergers and acquisitions, and trading volume.

Nikiforov teaches classes on investment and portfolio management and financial management at the Rutgers School of Business–Camden. His research studies how financial markets respond to the flow of information.

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