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The Drift

Amongst the greatest mysteries of this world, one counts whether the Hanging Gardens of Babylon ever existed, the low level of inflation in the US in the words of former Fed Chairwoman Yellen (see ‘The Big Fudge’ in September 2017), what happens to Tony Soprano after the screen was cut to black in the very last scene of the final TV series and… the post-earnings announcement drift (‘PEAD’) also called ‘The Drift’. This phenomenon was briefly introduced earlier this year in ‘Watch Your Words’. It deserves a deeper dive.

Fifty years ago, two accountants named Ray Ball and Philip Brown found in An Empirical Evaluation of Accounting Income Numbersthat a stock’s cumulative abnormal returns persistently drift up (down) – above (below) the normatively predicted price – in relation to firms announcing positive (negative) surprises on their quarterly earnings call. Most of that drift occurs during the first sixty days (i.e. about three calendar months) following the earnings announcement, just in time for the next quarterly results.

Their analysis has withstood the passage of time and many robustness checks. The Drift is one of the biggest thorns in the thighs of the Efficient Market Hypothesis. There is evidence of mispricing.

A possible explanation put forward by psychologists is that investors are naturally biased when processing information: They tend to overestimate the quality of private information whilst underestimating that of generally available public information. Other researchers simply demonstrate that processing intricate information requires time: As evidence, they show that the PEAD is larger for conglomerates than single-segment firms.

Whilst the Drift has been identified for decades, it has proven to be indestructible. Trading strategies and algorithms should have been able to arbitrage it away. And yet it has continued to exist. In the age of fast computing, ubiquitous media and advanced market regulation, the PEAD has been a persistent market anomaly.

Of course the PEAD could be an illusion, which is why it cannot be arbitraged. Its apparent permanent existence might only be the very proof of its inexistence. There is a sound logic to this argument. But it only makes the Drift even more mysterious.

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