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The Big Three: Behavioral Finance Insights in Pricing and Earnings Momentum

This article explores the concepts of pricing and earnings momentum in behavioral finance, with a focus on the works of DeBondt and Thaler, Fama and French, and Jegadeesh and Titman. It examines the underreaction of the market to earnings surprises, the effects of past winners and losers, and the relationship between earnings momentum and future GDP growth.

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The Big Three: Behavioral Finance Insights in Pricing and Earnings Momentum

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  1. Behavioral Finance Economics 437

  2. The Big Three • DeBondt-Thaler 1984 • Fama-French 1992 • Jegadeesh-Titman 1993

  3. “Price Momentum” or “Earnings Momentum” • Ball and Brown 1986 • Jegadeesh-Titman 1993

  4. Ball & Brown 1986 • Market “underreacts” to earnings surprises • Article generally ignored until Jagdeesh-Titman • Time span suggests that Ball-Brown effect may be the same thing as Jagdeesh-Titman

  5. Jegadeesh and Titman (1993) • Relative strength strategies, sometimes called “earnings momentum” strategies • Find past winners and and past losers (using 3 to 12 month holding periods) generate gains (winners gain; losers lose) • Construct W portfolio and L portfolio • W-L (using 6 month periods) earns more than12 % better than market portfolio • Longer term portfolios do best in next 12 months • Interpretation in “event time” • Doesn’t work in January

  6. Chan, Jegadeesh, Lakonishok 1996 • Is it earnings? Is it price? • They 7.7 percent six month gap between winner portfolios and loser portfolios using price momentum. • Conclusion (page 1709): “ In general, the price momentum effect tends to be stronger and longer-lived than the earnings momentum effect.”

  7. Chordia-Shivakumar, 2006 • Is it “pricing momentum” or “earnings momentum” that drives the “under-reaction” phenomenon? • Conclude the earnings momentum is the key factor. • Price momentum variables are a “noisy proxy” for earnings momentum

  8. Hong, Lee & Swaminathan 2003 • Earnings Momentum is the real driver of price momentum • Systematic relationship between earnings momentum and future GDP growth – hence a “risk factor” • This matters, because if there is a risk factor, then momentum might be consistent with EMH (which price momentum generally is not)

  9. Kothari, Shanken, Sloan 1995 • F-F are wrong • Beta does matter (explains returns of 6 to 9 % per year) KSS uses “annual” not “monthly” betas • B/M matters, but not as much as you think • Data snooping • Survivor bias in the data

  10. Chan 1988 (on DeBondt-Thaler) • Risks of loser are greater than risks of winners • So, they should get higher returns • But they don’t really, after adjusting for transaction costs

  11. Zarowin (1990) • Losers tend to be small stocks • When losers are compared to winners of equal size, there is little evidence of any return discrpancy • When winners are smaller than losers, winners outperform losers

  12. Lakonishov, Shleifer, Vishny, 1994 • Questions: • Do value stocks really beat out growth stocks (the F-F issue revisited)? • Are value stocks actually riskier • Is there a reason that value stocks do better? • Answers: • Yes, by 10 – 11 percent annually • No, they outperform is all periods • Yes, future earnings of value stocks are better than predictions – opposite for growth stocks

  13. The End

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