- Chan, Jegadeesh and Lakonishok
- A version of the paper can be found here.
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We examine whether the predictability of future returns from past returns is due to the market's underreaction to information, in particular to past earnings news. Past return and past earnings surprise each predict large drifts in future returns after controlling for the other. Market risk, size, and book-to-market effects do not explain the drifts. There is little evidence of subsequent reversals in the returns of stocks with high price and earnings momentum. Security analysts' earnings forecasts also respond sluggishly to past news, especially in the case of stocks with the worst past performance. The results suggest a market that responds only gradually to new information.
In 1993, Jegadeesh and Titman observed that a stock's past return has marginal predictive power for its future return, which is widely known as "momentum." In this paper, Chan, Jegadeesh and Lakonishok (1996) further show that momentum may be explained by market's underreaction to earning-related information as well. So the authors try to disentangle the sources of momentum premia based on these two separate factors: past return and earnings surprise.
Paper first evaluates two momentum strategies:
- Price Momentum: formed based on the past 6-month returns;
- Earning Momentum: formed based on past earnings surprises.*
*Earnings surprise is measured three ways: standardized unexpected earnings, abnormal returns around announcements of earnings, and revisions in analysts’ forecasts of earnings.
First, they find out that both momentum strategies are profitable and they are not subsumed by each other. Specifically, when past large, positive returns are not validated by positive earnings surprises, the price will then encounter a stronger correction in the future.
In other words, when both prices and earnings are moving in the same direction, the momentum premiums will be the highest.
So, both past return and earnings surprise have predictive power for the post-formation drifts in returns.
The Table below shows the results of a cross-sectional regressions of returns: the coefficient on past return is 5.7%. When introducing past earnings surprises, the coefficient decreases to 2.9%, but is still significant.
Then the authors study the overlap between price and earnings momentum. They find that price momentum effect tends to concentrate around earnings announcements. About 41% of the price momentum premium in the first six months occurs around announcement dates of earnings.
The Paper hypothesizes that these two momentum strategies draw upon the market's underreaction to different pieces of information.
Earnings momentum benefits from short-term underreaction to short-term earnings. Price momentum benefits from underreaction to a broader information set, including profitability.