Application of pattern recognition to portfolio management

Abstract

In this research the market’s reaction to earnings announcements is investigated. The investigation can be divided into three parts: testing whether earnings announcements convey any information to the market; finding any patterns in the market’s response to the earnings announcements and testing the exploitability of patterns through the simulation of trading strategies. The three part investigation essentially focuses on two parts of the market’s reaction to earnings announcements on the Johannesburg Stock Exchange (JSE) for the period 1991 to 2010. The first part focuses on the short–term market reaction around earnings announcements including the dynamics of the response and the information content of earnings announcements, the predictability of the earnings surprise and the exploitability of the predictability. We found that the magnitude of the cumulative returns for the days [0; 2] is on average positive and decreases with an increase in firm size. The average information content of earnings announcements also decreases with an increase in firm size. This therefore means information uncertainty decreases with size. The earnings surprise is on average found to be predictable for firms in the two smallest size categories and shares with relatively low liquidity. Proxies for the value effect and particularly the auto correlation structure of unexpected earnings provide some additional information to predict future unexpected earnings. Our findings regarding the auto correlation structure of the three–day reaction (event returns) to earnings announcements are consistent with that found by Bernard and Thomas [1]. We however found that the auto correlation is largely restricted to small size firms. The second part of the investigation involves the longer–term reaction to earnings announcements which includes investigating the statistical significance and exploitability of the post–earnings announcement drift (PEAD). The Post–Earnings Announcement Drift anomaly has been widely researched and confirmed for several markets around the world. It is observed that contrary to previous research conducted on the JSE that confirmed the overreaction phenomenon for the period 1975–1989 [2], evidence suggests that for the period under investigation the PEAD effect occurred on the JSE for the period from 1991 to 2010 and it is found to be statistically significant and independent of the size, value and/or momentum effect. All these effects are however found to have a significant influence on the magnitude of the PEAD effect. The results indicate that the market reacts very quickly to the announced earnings and it is not until about the 20th to 40th trading day after the earnings announcement that the market starts drifting in the direction of the initial reaction. The market therefore seems not to under react to the earnings information at first, but that it receives confirmation in the two months following the announcement that is indicative of better future prospects and that the higher than expected earnings might persist. In retrospect, when only considering earnings news, it thus seems that the market under–reacted to the information released at the earnings announcement. We however found no conclusive evidence in the trading simulation analysis to indicate that the PEAD effect can be exploited on a profitable basis. What the simulation analysis however did reveal was that the liquidity limitations imposed by the simulator lowered the overall returns achieved. It can therefore be argued that the PEAD effect is related to market frictions that prevent arbitrageurs to exploit the apparent profit opportunity. Our results tend to agree with the limited arbitrage hypothesis of Mendenhall [3] who argued that the magnitude of PEAD is related to the risk faced by arbitrageurs and Chordia et al. [4] who found that the PEAD anomaly mainly occurs for the highly illiquid shares.