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Conclusions

Unless we understand why a particular investment strategy works, we should be skeptical about its out-of-sample performance. There are several competing hypotheses concerning the profitability of contrarian strategies for short- or long-horizon returns. However, there is a glaring lack of explanations for the continuation in stock prices over intermediate horizons (short of sweepВ­ing the issue under the rug by relabeling the phenomenon as part of the "normal" cross-section of expected returns).

This paper fills in some of the gaps in our understanding of two major unresolved puzzles in the empirical finance literature: why two pieces of publicly available information ”a stock's prior six-month return and the most recent earnings surprise ”help to predict future returns. The drift in future returns is economically meaningful and lasts for at least six months. For example, sorting stocks by prior six-month return yields spreads in returns of 8.8 percent over the subsequent six months. Similarly, ranking stocks by a moving average of past revisions in consensus estimates of earnings produces spreads of 7.7 percent over the next six months.

Our results are robust with respect to how we measure earnings surprise: as standardized unexpected earnings, abnormal returns around announcements of earnings, or revisions in analysts' forecasts of earnings. In general, the price momentum effect tends to be stronger and longer-lived than the earnings momentum effect.

The bulk of the evidence suggests that the drifts in future returns are not subsequently reversed, so momentum does not appear to be entirely driven by positive feedback trading. The price continuations are particularly notable for stocks with the worst past earnings performance, whose returns are below average for up to three years afterwards.

There is stronger evidence of subseВ­quent correction in prices when large, positive prior returns are not validated by good news about earnings. In the first year following portfolio formation, stocks ranked highest by prior return but lowest by abnormal announcement return earn a rate of return (21.3 percent) that is not very different from the average of 20 percent. The fact that returns for the past winners are high only in the first subsequent year, but are not much different from the average in the second or third years, poses a challenge for risk-based explanations of the profitability of momentum strategies. More direct evidence from a three-factor model also suggests that the profitability cannot be explained by size and book-to-market effects.

An alternative explanation is that the market responds gradually to new information. Since earnings provide an ongoing source of information about a firm's prospects, we focus on the market's reaction when earnings are released. Indeed, a substantial portion of the momentum effect is concentrated around subsequent earnings announcements. For example, about 41 percent of the superior performance in the first six months of the price momentum strategy occurs around the announcement dates of earnings. More generally, if the market is surprised by good or bad earnings news, then on average the market continues to be surprised in the same direction at least over the next two subsequent announcements.