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Explanations:

Why Post-Earnings-Announcement Drift Occurs,

Why Stock Prices Tend to Rise After a Stock Split,

and Some Reasons Why Managements Smooth Earnings

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also explains (1) why the size of the drift varies by size of

the company, (2) that the market is not efficient, (3) why stock

prices tend to rise after a stock split, and (4) some of the

incentives for managements to smooth earnings.

Keywords: post-earnings-announcement drift; models; capital

asset pricing model; efficient market hypothesis;

market microstructure; stock splits; income smoothing;

earnings management; economic analysis; field study

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I. INTRODUCTION

Ball and Brown (1968) identified post-earnings-announcement

drift (PEAD) decades ago. Since the drift is incompatible with

our current theoretical underpinnings, then so long as it

remains unexplained, we cannot be assured that we have a correct

understanding of the capital markets. Research subsequent to

Ball and Brown (1968) has repeatedly and overwhelmingly

confirmed that PEAD does exist, but has not explained why PEAD

exists. The purpose of this paper is to explain why post-

earnings-announcement drift occurs.

The Importance of the Drift

This work has already been exposed for comment and review.

Earlier reviewers have criticized the inclusion of information

concerning what the phenomenon is and why the phenomenon is

important, in essence claiming that everybody knows that anyway.

However, not all possible readers are well-trained in capital

markets research (e.g., those whose training is in behavioral

research), so it is important to include the information for

such readers. Further, inclusion of this information is

important because capital-markets researchers who will become

well trained in the future may well have had this method of

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analysis incorporated into their training. Accordingly,

information on the importance of the drift is included in the

Appendix.

Is the Drift a Real Phenomenon?

Ball and Brown (1968, 170-173) found abnormal returns both

before and after the quarterly announcement of earnings. While

the abnormal returns before the earnings announcement are

relatively easy to theorize away as leakage of information into

the market, such is not the case with respect to the abnormal

returns after the earnings announcement (i.e., PEAD). Fama

(1998, 283) stated that most long-term return anomalies tend to

disappear with reasonable changes in technique or when (288)

alternative approaches are used to measure them, but Fama

(1998, 304) stated this about PEAD specifically:

Which anomalies are above suspicion? The post-earnings-announcement drift first reported by Ball and Brown (1968)has survived robustness checks, including extension to morerecent data (Bernard and Thomas, 1990; Chan et al., 1996).

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Liu, Strong, and Xu (2003, 90) said that "Fama (1998) refers to

PAD 1 as 'the granddaddy of underreaction events' and as the only

established anomaly above suspicion."

How Prior Research Was Done

The traditional methodology of PEAD research can be

summarized as follows. First, portfolios (varying in number)

were formed based on the magnitude and direction of earnings

surprises for quarterly earnings announcements. Second, the

actual market prices of securities were compared to prices

derived from a normative model (i.e., CAPM). Third, a

divergence from the normatively predicted price was found.

Fourth, portfolios with positive earnings surprises were found

to have had positive drift above the normatively predicted

price, while portfolios with negative earnings surprises were

found to have had negative drift below the normatively predicted

price. Fifth, the amount of drift was found to be monotonically

positive for increasing positive earnings surprise portfolios,

and monotonically negative for increasing negative earnings

1that is, the drift, which some authors call post-announcement

drift, or PAD

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surprise portfolios. Sixth, no satisfactory explanation for the

existence of PEAD was found. As Ball (1978, 105) stated, "the

notable feature of the anomaly is its consistency across the

studies."

Organization of the Work

Part II reviews some literature relevant to PEAD. Part III

discusses CAPM as a pricing model. Part IV uses a different

pricing model than CAPM to analyze the post-earnings-

announcement drift, plus the results of a field study to explain

why the drift occurs. Part V contains tests of hypotheses; the

results are consistent with the results in Part IV, but they

would not be consistent if the analysis in Part IV were

incorrect. Part VI discusses the implications of the analysis.

The Appendix contains information concerning why the drift is

important.

II. SOME BACKGROUND RELEVANT TO POST-EARNINGS-ANNOUNCEMENT DRIFT

Securities Markets

The world value of publicly traded securities (whether

equity or debt) plus the derivatives based on those securities

is a very large number. As a result, both academics and

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practitioners have devoted a great deal of effort to the theory

of capital markets, including the "proper" valuation of capital

assets. The PEAD anomaly exhibits a divergence of actual from

theoretical market prices, which means that present theory is

not correct.

The Post-Earnings-Announcement Drift Anomaly

Expressed simply, (1) stock prices adjust to a new level

upon an announcement of earnings, but (2) after the

announcement, prices begin to drift relative to the market for a

period of approximately sixty trading days, or about three

calendar months, then (3) make another significant adjustment

around the announcement of the following quarter's earnings.

Over a period of decades, there have been many published studies

by numerous researchers, typically resulting in a finding of

post-earnings-announcement drift for post-earnings-announcement

periods of months or quarters. Table 1 contains a partial list.

------------------------------

Insert Table 1 about here

------------------------------

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adjustments that occur at those dates (320) (Bernard andThomas 1990, 305-306 and 320).

! Ball and Brown (1968) first documented post-earningsannouncement drift. Subsequent researchers sought eitherto examine the robustness of Ball and Brown's findings orto investigate the extent to which drift was observedbecause of the research methods used rather than because ofa market inefficiency. After 30 years of research, drifthas been shown to be very robust, and it remains anapparent market inefficiency (Soffer and Lys 1999, 308).

! Post-earnings announcement drift is among the mostpersistent market anomalies. ... Post-earningsannouncement drift ... is the predictability of abnormalreturns after the earnings have been announced. Ball andBrown (1968) initially observed the drift. Severalsubsequent studies have examined the phenomenon in greatdetail. This anomaly has persisted for over 33 yearsdespite extensive research to explain it (Asthana 2003, 1).

Present Theory of How Capital Markets Value Assets

The present paradigm of how capital markets value assets

consists of a combination of the capital asset pricing model

(CAPM) plus the efficient market hypothesis (EMH). The capital

asset pricing model is a normative model for the valuation of an

asset. The efficient market hypothesis addresses the speed with

which prices change.

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The Capital Asset Pricing Model (CAPM)

The capital asset pricing model (CAPM) (Copeland and Weston

1979, 169) is

The expected return on any security equals the risk-free rate

plus [(the expected market rate less the risk-free rate) times

(the covariance of the security with the market divided by the

variance of the market return)].

Observe that the risk-free rate, the expected market rate,

and the variance of the market return do not differ across

securities. Given an initial price observed in the market, the

expected return during a period can be translated into the

equilibrium price of the risky asset (Copeland and Weston 1979,

170). Thus, the CAPM becomes a normative pricing model. In the

capital asset pricing model (CAPM) formula, there is only one

term which varies by security, so--at least, according to the

formula-- the price of an asset is determined by its covariance

(which is measured by beta)--how it moves relative to the market

as a whole; nothing else matters, and nothing else can change

the price relative to the market.

) RVAR(

) R , RCOV(] R-) R[E(+ R=) R E(m

m j f m f j

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The Efficient Market Hypothesis (EMH)

The concept of the efficient market is one in which the

marketplace uses information as soon as the information becomes

available, and immediately evaluates all the effects of that

information in setting asset prices. The information and its

effects are not limited to factual information; the effect may

exist only on the expectations of market participants. Because

the efficient market hypothesis does not explicitly state a

formula for valuing assets, the concept that changes in

expectations can affect securities' values is compatible with

the efficient market hypothesis.

! In an efficient capital market, security prices fully

reflect available information in a rapid and unbiasedfashion and thus provide unbiased estimates of theunderlying values (Basu 1977, 663).

! A market in which prices always fully reflect availableinformation is called efficient." (Fama 1970, 383)

! I take the market efficiency hypothesis to be the simplestatement that security prices fully reflect all available

information (Fama 1991, 1575).

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The Effect of Combining the Capital Asset Pricing Model and theEfficient Market Hypothesis

A problem arises from the interaction of the EMH with a

mechanical application of the CAPM. If CAPM and EMH are both

correct simultaneously, then CAPM is how the market sets the

price, and everybody knows the correct price. Any movement away

from this price must be interpreted as mispricing. If this

mispricing occurs in an efficient market, then sophisticated

market participants can be expected to buy or sell as necessary

to force the security's price back to its theoretically

"correct" price. Therefore, PEAD cannot occur if CAPM and EMH

are both correct simultaneously.

Further, manipulation of any security's market price is

impossible. No buyer would pay more than the publicly known

CAPM price, and no seller would accept less than the publicly

known CAPM price. That is not what is observed to happen in

reality. Market manipulation occurs to such an extent that the

Securities and Exchange Commission does not even go after the

small cases.

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! One argument supported by the EMH contends that if anysystematic method of obtaining abnormal excess returnsexists and if that method becomes known to the public, thenthe mechanics of an efficient market will negate therealization of any further benefits derived from the use ofthat method (Bidwell and Riddle 1981, 211).

! Perhaps the evidence most damaging to the naive andunwavering belief in market efficiency was the accumulationof results indicating the existence of persistent priceadjustments after earnings announcements were made; this isobviously incompatible with the instantaneous-adjustmentproperty of informationally efficient markets. ... Insome cases, the studies even implied that excess returnscould be earned by using investment strategies based onprice-change persistencies subsequent to earningsannouncements (Lev and Ohlson 1982, 284-285).

! Bernard and Thomas (1990, 308) called post-earnings-

announcement drift

. . . the most direct evidence . . . that a market-efficiency anomaly is rooted in a failure of information to

flow completely into price. The evidence also emphasizesthat even in a market where prices fail to reflect allavailable information, one can still observe unusual stock-price activity concentrated around news releases. Thepuzzling question is, if a portion of the "news" becamepredictable months earlier, why did the associated pricemovements not occur then?

! ...it is puzzling that, although so many years have gone bysince the post-announcement drift was first documented by

Ball and Brown (1968), arbitrageurs still have not fullytraded on this phenomenon and thereby eliminated it (Bartov1992, 622).

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! Hew, Skerratt, Strong, and Walker (1996, 283) stated:

Over the last quarter of a century a number of US researchstudies have reported an empirical phenomenon that has cometo be known as post-earnings-announcement drift (henceforthreferred to as PAD). Loosely speaking, the PAD phenomenoncan be described as a tendency for abnormal stock returnsto be predictable on the basis of past earnings news. Inother words, share prices fully react to earnings news onlywith a considerable lag.

The PAD phenomenon directly challenges the semi-strong formof the efficient markets hypothesis (EMH), which statesthat the market reacts fully and instantaneously to allpublicly available information. Of all the various sourcesof public information about a company, earnings isgenerally regarded as the single most important, regularlyreported item (see, for example, Beaver, 1981a, p. 135).Thus, if it can be shown that market prices fail to fullyimpound earnings information, this will seriously underminethe EMH. It is primarily for this reason that many leadingacademics regard PAD as one of the most serious empiricalchallenges to the EMH (see Ball, 1992 and Lev and Ohlson,

1982).

! Among the documented departures from market efficiency thepost-earnings-announcement drift (PEAD) is arguably themost puzzling. ... While the PEAD is well documented inthe literature, the reasons for the persistent under-reaction to earnings announcements are not well understood(Jacob, Lys, and Sabino 2000, 330).

! Ball and Brown (1968) document that a systematicrelationship between current unexpected earnings and stockreturns continues even after earnings are announced. Thisrelation implies that earnings information already publiclyavailable can be used to predict abnormal stock returns, aphenomenon termed post-earnings announcement (PEA) drift,

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which is a violation of the (semi-strong) efficient markethypothesis (Kim and Kim 2003, 383).

Importance of the Belief in Market Efficiency

The reigning paradigm in capital markets research assumes

market efficiency. The post-earnings-announcement drift is

evidence which contradicts the assumption because the market,

having known since at least 1968 that the drift exists,

nevertheless does not adjust for it.

! Finance theory is grounded on the assumption that securityprices adjust to new information as it becomes available(Latan and Jones 1977, 1457).

! The proposition that securities markets are efficient formsthe basis for most research in financial economics. Avoluminous literature has developed supporting thishypothesis. Jensen (1978) calls it the best established

empirical fact in economics. Indeed, apparent anomalies .. . are treated as indications of the failures of models .. . rather than as evidence against the hypothesis ofmarket efficiency. ... Despite the widespread allegianceto the notion of market efficiency, a number of authorshave suggested that certain asset prices are not rationallyrelated to economic realities. ... Arrow (1982) hassuggested that psychological models of "irrational decisionmaking" of the type suggested by Tversky and Kahneman(1981) can help to explain behavior in speculative markets.These types of claims are frequently dismissed because they

are premised on inefficiencies and hence imply the presenceof exploitable excess profit opportunities. This paperargues that existing evidence does not establish thatfinancial markets are efficient. . . . (592) ... Aclassic example is the discounts on closed end funds. Eventhough the underlying assets are easily valued, market

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values do not accurately reflect fundamentals (600). ...The evident difficulty economists have in explaining anysignificant amount of the variations in speculative priceson the basis of "news" about fundamentals also suggeststhat valuation errors are being made continuously (600)(Summers 1986, 591-592).

Get the Picture

The post-earnings-announcement drift phenomenon consists of

a drift, with a predictable pattern, in the prices of individual

securities relative to the market. Those prices of individual

securities increasingly diverge over time from the normative

CAPM price. Table 2 lists a number of studies which contain

pictorial representations of the drift.

------------------------------

Insert Table 2 about here

------------------------------

The variety of pictorial representations and variety of

accumulation periods indicate that there is no standard method

of pictorially representing the post-earnings-announcement drift

phenomenon. Consequently, Figure 1 displays a generalized

pictorial representation of post-earnings-announcement drift for

a positive earnings surprise, based on the text of earlier

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that a firm announces positive (negative) unexpectedearnings for quarter t , the market tends to be positively(negatively) surprised in the days surrounding theannouncement for quarter t + 1.

Booth, Kalunki and Martikainen (1996, 1197) summarized

Bernard and Thomas (1989 and 1990) as suggesting "that at least

a portion of the price response to new information around

earnings announcements is delayed. The delay might occur, for

instance, because traders fail to assimilate available

information, or because of costly information processing."

III. PREVIOUS TESTS OF CAPM AS A PRICING MODEL

Previous researchers accepted CAPM as being the way the

capital market prices an asset, and when they found PEAD, they

concluded that they had found an anomaly. Unfortunately, they

did not start from the beginning; they assumed that CAPM is

correct rather than tested whether CAPM is correct. As Foster,

Olsen, and Shevlin (1984, 577) stated:

Assumptions typically made in these tests include that thetwo-parameter asset pricing model...--CAPM--is

descriptively valid....

If the early researchers would have taken the position that

CAPM was a hypothesis (null hypothesis: the market values

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securities according to CAPM) rather than a fact, then their

work which showed a market-price drift from the CAPM price would

have led them to conclude that the market does not price

securities in accordance with the capital asset pricing model.

Instead of saying that they found an anomaly where the actual

market price differs from the correct price per CAPM, they would

have said that CAPM does not accurately model the correct market

price .

The Nails in the Coffin

------------------------------

Insert Figure 2 about here

------------------------------

Consider Figure 2. Take a time line during which post-

earnings-announcement drift has continuously been found by using

CAPM as a normative price. (Recall that Ball and Brown 1968,

165 and 167, used data from 1946 to 1966.) Take any Point A

significantly after the start of the entire time period, assume

that this is the starting point of a study which finds PEAD, and

assume that the CAPM price is correct at this starting point.

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Thus, at any intermediate Point B, and at any final Point C,

because of PEAD, we know that the CAPM price is not the correct

price. However, Point A is itself an intermediate and/or final

point during a period when there was drift, so Point A is itself

a Point B or a Point C with regard to some earlier starting

point. Thus, Point A illustrates that the CAPM price is correct

only by assumption, but wrong by proof.

Beaver (1974, 568) said, "to say that a given model is

deficient implies that there is a 'better' model." The

preceding information indicates CAPM is deficient. This leads

to the question: What pricing model should be used instead of

CAPM? To answer this, we must first understand that the CAPM is

a model, and just a model. As a model, there are assumptions

which underlie the model.

! The CAPM is developed in a hypothetical world where thefollowing assumptions are made about investors and theopportunity set:

5. Asset markets are frictionless and information iscostless and simultaneously available to all

investors.

(Copeland and Weston 1979, 160-161)

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! A perfect capital market is a key assumption in recenttheories of security pricing. 2 It is assumed that the costsof transactions, information-gathering, and portfoliomanagement are all zero.... (Mao 1971, 1105)

So far, however, no one has examined the implications ofnonzero costs of transaction, information, and management.... ...the question arises of how the theory of securitypricing is affected by this form of market imperfection(Mao 1971, 1106).

! The asset pricing models rest upon the twin assumptions ofrational behaviour and perfect markets. In this context, aperfect market is one in which there are no transactionscosts and all individuals are price-takers (Ball, Brown,and Officer 1976, 2).

CAPM was developed as a model for a frictionless (costless)

market, but it is being applied to a market which is not

costless. Prior researchers have assumed a costless market

because they used the capital asset pricing model. However, if

no investor is paying any costs, that also means that no

brokerage firm or broker is receiving any revenue. Observe that

brokerage firms are in business to make a profit, which requires

that they receive revenue, and further observe that individual

brokers have self-selected into an occupation in which they are

paid on the transactions completed by their customers. Since

2Maos footnote at this point explicitly mentioned Lintner,Sharpe, Mossin, and Fama.

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brokers want to earn more money rather than less, they have an

incentive to cause their customers to engage in transactions.

IV. A PRICING MODEL THAT WORKS

Precisely because nobody is selling an "overpriced"

security to force it down to the CAPM price, we can conclude

that all those who wanted to sell have sold, and as much as they

wanted to sell. Because the market price is not even higher, as

would be the case if more people would have bought, we can

conclude that all those who wanted to buy have bought as much as

they wanted and could afford to buy. Thus, by definition, the

security price is a market price.

According to standard economic theory, when there is no

interference with the market--as in the case of a large,

centralized, liquid auction market with many buyers and sellers-

-the price of everything is set by supply and demand. Supply

and demand (possibly the most fundamental model in all of

economics) works in explaining not only prices of individual

securities, but also the price level of the entire market.

According to the model of supply and demand which is taught to

undergraduate business students as part of their required core

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business curriculum, this market price is set by the

intersection of a supply curve and a demand curve, as shown in

Figure 3.

------------------------------


------------------------------

Now let us return to Figure 1. This pictorial

representation of post-earnings-announcement drift for a

positive earnings surprise represents a portfolio. It can also

be defined as representing what happens to the average security

in the portfolio. However, the line representing the price

relative to the market is merely a transformation of a market

price, which can be analyzed in the following manner.

1. Let us take three points J, K, and L on the PEAD, as

shown in Figure 4.

------------------------------


------------------------------

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2. Let us show only the three points J, K, and L, as

shown in Figure 5.

------------------------------


------------------------------

3. Since these three points represent price points (even

if in the pictorial representation of the drift they

are transformations of price points), let us rename

the axes as shown in Figure 6. (Alternatively,

subtract out the effects of the market, and one

obtains the same Figure 6.)

------------------------------


------------------------------

4. Let us draw in the supply curve S 0 and demand curve D 0

which intersect to create price point J, as shown in

Figure 7.

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one shift of the demand curve plus at least one shift of the

supply curve. (In order to simplify the analysis, possible

changes in slopes and shapes of the curves are ignored.)

By analogy, but without repeating the detailed analysis,

the post-earnings-announcement drift for a security with a

negative earnings surprise consists of two components, at least

one shift of the supply curve plus at least one shift of the

demand curve. Next I will explain why there are shifts in both

demand and supply.

Not All Investors Are Market Experts

The capital asset pricing model and the efficient market

hypothesis each assume that all investors are experts at

investing. This is false. Consider the following quotations.

! A national survey of investor knowledge concludes thatfewer than one in five U.S. investors have a basicunderstanding of financial terms and the ways varioussecurities work (staff reporter for The Wall Street Journal 1996, A6).

! Charles Schwab Corp., the giant pioneer of discountbrokers, is preparing to roil the financial-services worldwith a bold move that could make it the McDonald's offinancial advice.

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Departing from its no-frills roots, the San Francisco firmlate this year plans to launch what amounts to a fast-foodversion of money management....

Schwab says it has no choice but to cater to its customers,who now want a dab of hand-holding along with their low-cost services. "The nature of people coming to Schwab haschanged dramatically," says ... Schwab's president. "Weare going into the advice business because our customersare pulling us into it." (Schultz and O'Brian 1996, C1)

Many people rely on someone else, such as securities

brokers, to tell them what to buy or sell.

! Until recently, little was known in a formal way about thedecision processes of investors (American AccountingAssociation 1972, 409).

! ...on what basis and from what sources do private investorssecure information upon which to make decisions about theirinvestment or disinvestment in corporate stocks?

Stockbrokers were rated most important by 46.8 percent

(Parker 1981, 38). When I had my own certified public

accountant (CPA) firm, I met with a number of securities brokers

and discussed (among other things) their training, their

licensing, regulation, and their actual practices whereby they

get customers to buy securities. In other words, I conducted a

field study, and as Abdel-khalik and Ajinkya (1979, 45) state

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about field studies, "external validity and the practical

significance of the results are high."

Securities Brokers Sell Securities

The capital asset pricing model is deficient because it

implicitly assumes that securities brokers have no influence

over who buys or sells what, nor at what price. Brokers are

implicitly assumed to be mere order takers rather than

instigators of transactions. This is a fallacy, as the assumed

mathematically rational investors would all flock to discount

brokers for cheap execution of orders rather than pay high-

priced brokers. Brokers have self-selected into an occupation

in which they do not get paid unless they get clients, and those

clients engage in transactions. One of the responsibilities of

the brokerage firm's securities analysts is to provide a "story"

which the brokers use to "pitch" (i.e., sell) that security to a

client.

The economic analysis in this paper explains what happens.

This discussion of the process by which transactions occur

explains why it happens, and is based on a field study in which

I spoke with branch managers and brokers in multiple securities

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firms large, medium, and small. Some of the brokers had been so

successful over a multi-year period at selling securities that

they had been asked to help train new brokers. An assumption

inherent in this article is that brokers who have proven so

successful at selling securities over a multi-year period that

they have been asked to train other brokers, actually know how

to sell securities. Instead of using models which fail to

explain why PEAD occurs, this article uses the behavior of real

humans who are experts at how the market really works to explain

why at least some things happened the way they did, without

claiming to explain everything which has ever been observed.

This is an accepted approach in economics, and some certifying

examinations (e.g., the Uniform CPA Examination) directly test

knowledge of economics. Henderson (2005, A16) said of

Schelling, a winner of the Nobel Prize in Economics:

Mr. Schelling did it as a true social scientist, withspectacular results. ... His specialty was understandingthe behavior of real humans.... ...Mr. Schelling firsttold illustrative stories and then, using words, showed whythings happened the way they did.

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What Securities Brokers (i.e., Experts in Market Microstructure)and Published Sources Told Me About Why Market TransactionsOccur

Not all clients buy right away the stock being pushed by

the broker. Sometimes the broker must get back with them,

whether once or repeatedly. Many investors like predictability

in their investments. While academics refer to risk and to

stockholders as agents who specialize in risk-bearing, at least

some of the investors want safety, which is proxied by

predictability. 3

Consider the following items.

! Securities are not bought in this country; theyre sold.Somebodys broker calls them up and says buy XYZ stock, andthey just buy it, says John Fedders, a Washington, D.C.,lawyer who is the former director of the SECs Division ofEnforcement (France 1996, 83).

3This is why companies smooth earnings. Companies do not

sell their stocks; securities brokers sell their stocks.

Brokers would rather have an easy sell than a hard sell.

If company managements do not smooth their earnings to make

it easier for the brokers to sell their stock, then the

brokers can just sell some other company's stock.

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! What is a broker? Hes a salesman. (Wynter, quoting abrokerage firm founder who recruits securities brokers,1998, B1)

! Smith Barney Inc. is raising the bar for its brokers toearn bonuses. ...

The Smith Barney plan is part of a broader trend of higherhurdles for brokers. In the past several years, somebrokerage firms have increased the annual production quotasfor brokers to meet in order to keep their jobs or earnmore than bare-bones commissions.

The bulk of pay for most of the nation's about 93,000stockbrokers is tied directly to the trading commissionsthey generate (Siconolfi 1995, C22).

Why Post-Earnings Announcement Drift Occurs, Why CompaniesSmooth Earnings, and Why the Market Is Not Efficient

Brokers pitch the same stock to different clients. This

makes sense to brokers because they can learn one story,

supplied by one of the brokerage firms analysts, and repeat it

to different clients. This cuts down on the work brokers have

to do, but it means that the brokers are in danger of alienating

multiple customers if the story is wrong.

To help assure that the story is right, instead of issuing

reports shortly before new earnings information becomes

available, analysts delay issuing their reports until after the

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company has announced its earnings. After all, as brokers

pointed out to me, why should customers believe the story when,

right after you pitch a stock to them, the company announces

earnings which are down from what you said they would be? The

need for time to physically accomplish all the tasks involved in

issuing an analysts report accounts for the delay after the

earnings announcement before the drift begins. (Recall that

during the period of the early PEAD studies, not even the

professional market participants had instant electronic

communications, so they relied instead on slower means.)

Analysts do not issue a report on the same security every

quarter, so when a report is issued, it is something new instead

of something stale.

Once the brokers have the analysts report available,

different brokers react differently. Some brokers are always

rushing to get the latest stock to push. Others are more

comfortable continuing to push the stocks for which they already

know the story and how their customers are likely to react; they

are slower to start pushing the different stock mentioned in the

new analysts report. But by pushing the stock, the brokers are

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causing an outward shift in the demand curve for that particular

stock. (See Figures 7 and 8.)

Not all customers want to buy the stock right away. Some

want to wait and see what happens to the stock and its price.

Brokers pitch the reliability of earnings--a reason for

companies to smooth their earnings--yet are sometimes told that

maybe the customers will buy it later. (For example, the

substance of Ip [1997, C1 and C2] is that investors look for

certainty about their stocks earnings.)

What do brokers do now?

Brokers develop a sense of whether they can sell a

particular customer or not. After all, they are salesmen, and

they make their living by getting people to do something. It

makes no sense to most successful brokers to pitch something

else to a customer who will not buy what is being pitched today,

because (a) the broker will just confuse the customer, and (b)

if the customer did not buy the first stock, he is not likely to

buy the second stock. Consequently, the broker makes some note

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to contact the customer again around the time the company is

getting ready to release its next earnings report.

Some customers, if they indeed will buy, want to buy before

the next earnings announcement. Other customers want to

actually see that the company has indeed reported particular

earnings before they buy. In either case, the customers want to

see that the reported earnings were what the broker told them to

expect, which is another reason why market professionals like

smoothed earnings. Some customers want to wait for yet another

period before they buy, so they can be sure that the earnings

the broker tells them to expect actually are the reported

earnings. All this points to market professionals liking

smoothed earnings.

Verecchia (1981, 271) said that at an intuitive level,

there is a belief that observed abnormal volume around the

release of earnings reports must mean something, but he offered

no explanation of why the abnormal volume occurs. When brokers

all across a brokerage firm contact their wavering customers

around the time of the next earnings announcement, they reach

some customers who will buy, some who want to wait and see what

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the announced earnings are and then buy, some who either cannot

be reached or who are out of town for a short time, and some who

want to wait and talk it over with someone (typically a spouse)

before they buy the stock. This physical process, caused by a

change in the amount of broker sales activity in the stock

around the time of the next earnings announcement, accounts for

the observed nonrandom drift around the ( t + 1) earnings

announcement and later announcements. It has been observed that

a disproportionately large fraction of postannouncementdrift is concentrated in the few days preceding andincluding the next quarter's earnings announcement (Bernardand Thomas 1989, 29-30).

Abarbanell and Bernard (1992, 1190) found a "concentration of

the post-earnings-announcement abnormal returns around

subsequent earnings announcements . . ." above what drift would

be expected if the drift occurred randomly. This simply results

from brokers following up with customers, trying to sell the

same stocks they tried to sell before. Brokers are not

necessarily following up with every customer and concerning

every security, but only those customers who the broker thinks

can be sold particular securities. Further, because this

security is again coming to the attention of the broker, the

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This first hypothesis is expected to be impossible to

satisfy unless this work contains the correct solution to what

causes post-earnings-announcement drift.

If A, then B

H2: On average, companies experiencing post-earnings-

announcement drift have earnings more extreme than expected. In

other words, on average, their standardized unexpected earnings

(SUEs) are positive.

This hypothesis number two is related to the way securities

brokers sell stocks to their customers.

If not A, then not B

H3: On average, once the SUEs of companies experiencing

post-earnings-announcement drift turn negative, the drift either

disappears or turns negative.

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This hypothesis number three is related to the fact that

once the earnings story is no longer there for the securities

brokers to use to get their customers to engage in transactions

on those stocks, the extra transactions caused by the brokers

efforts cease, and so do the effects on prices of those extra

transactions.

The Evidence Which Tests the Hypotheses

Bernard and Thomas (1989 and 1990) and Ball and Bartov

(1996) used the same data set. Ball and Bartov (1996, 325)

state that data from their studies were kindly supplied by

Bernard and Thomas. Therefore, the evidence all comes from the

same data set. Concerning hypothesis two, Bernard and Thomas

(1990, 310, Table 1) report that lagged standardized unexpected

earnings are positive in the first quarter for drift firms, and

remain positive until quarter four. Ball and Bartov (1996, 326)

state that their own Table 1 reports pooled regressions of SUE

on its four lagged values. Their signs follow the familiar

(+,+,+,-) pattern. Thus, research hypothesis two is supported.

Concerning hypothesis three, Bernard and Thomas (1990, 327,

Table 5) report that abnormal returns (ARs) using lagged

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quarterly earnings information are negative during the three-day

period [-2,0] at quarter 4the same time that SUE turned

negative. One well-known phenomenon from the original Ball and

Brown (1968) paper is that prices change even before earnings

are announced. Ball and Bartov (1996, 327, Table 2) also report

that cumulative abnormal return (CAR) for lagged quarterly

earnings information becomes statistically significantly

negative at quarter 4. Thus, research hypothesis three is

supported.

Because both research hypothesis two and research

hypothesis three are supported by reference to multiple

previously published works which all used the same data set,

research hypothesis one is also supported. Therefore, all three

of the research hypotheses are supported.

VI. IMPLICATIONS OF THE ANALYSIS

Why Smaller Firms Have Larger Drifts

Foster, Olsen, and Shevlin (1984, 598) reported that "the

smaller the firm size, the larger the absolute magnitude of CAR j

in the [+1, +60] period...." Bernard and Thomas (1989, 9)

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stated, "we replicate those results and demonstrate that they

persist over a longer time period."

PEAD is more pronounced for small firms than for large

firms because large firms have much more ongoing transaction

volume than do small firms. Consequently, when brokers start to

push a large firms stock, the additional volume generated is

not as big a percentage difference as it is for a small firms

stock. Brokers push the demand curve out more for a small firm

with low volume than for a big firm with high volume. More than

one broker has told me personally that, by himself, he can move

the price of all but the biggest stocks if he really believes in

it and starts selling it to all his customers.

Why the Market is not Efficient

The market is not efficient because not everybody receives

the same information at the same time. Companies guide

analysts toward reasonable earnings expectations. The best big

customers of the analysts firm get the news first. Then word

gets out to the retail brokers, who in turn call their own best

customers first. The information is still being used months

later to pitch the stock to customers who wavered earlier.

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Consider this real-life example. I was working in South

Carolina one day when I heard from a reliable source that not a

single truckload of freight had moved in Pittsburgh,

Pennsylvania the previous day. Some small shippers had been

crying for weeks for someone to come pick up a load, but had not

been able to get anyone to come because the truckers were so

busy with bigger shippers. Now, even those single loads had

been picked up, and nobody had any freight to be moved.

Obviously this meant that economic activity in Pittsburgh had

slowed from what it had been previously, so it had predictive

value for earnings of companies whose activities were

concentrated in Pittsburgh. Anyone who had access to that

information about lack of freight could conduct transactions

during quarter t based on it. However, other people would never

receive the information and so would be forced to wait for

earnings guidance about quarter t ahead of the earnings

announcement; such guidance could occur during or after the end

of quarter t . Still others would not be informed of the

information or its effects until after the earnings

announcement--maybe months later--in quarter ( t + 1) or later.

Yet others would be presented with a story after earnings for

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quarter t had already been announced in quarter ( t + 1). Then,

some investors would not buy until sometime around the

announcement of earnings for quarter ( t + 1), to see whether the

broker's story is reliable. Thus, by definition, the market is

not efficient because people receive and act on the same

information at different times . Researchers have failed to

realize this because they have learned so well the concept of

the efficient market hypothesis (EMH). Concerning the EMH, a

quick reaction has been mistaken for a complete reaction.

This section has explained positive post-earnings-

announcement drift. Negative post-earnings-announcement drift

occurs when brokers try to get customers to sell securities

which report earnings lower than the expectation. For

unsophisticated, unknowledgeable investors, the expectation is

indeed naive: how this report compares to the previous one

(that of last year or last quarter). The broker's incentive is

to get the customer to sell the security and then use that money

to buy something else. This pitch that the customer should sell

a bad stock and buy something else results in two commissions,

not just one.

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Stock Splits la Fama, Fisher, Jensen, and Roll (1969)

Numerous individual investors believe that buying a stockthat splits is profitable, but nobody can really explainwhy that should be. ... Microsoft splits in half. Whatchanged? To an economist its absolutely bogus. Samecompany, double the number of shares at half the price.Yet it seems to work.... (Ip 1998, B1)

Ball, Brown, and Finn (1977) replicated and extended Fama,

Fisher, Jensen, and Roll's (1969) study of stock splits.

Companies which split their stocks have no intrinsic difference

in value, yet Fama, Fisher, Jensen, and Roll (1969) found a

price increase in the United States market, and Ball, Brown, and

Finn (1977) found a price increase in the Australian market.

The price increase has not been accounted for, although

Ball, Brown, and Finn (1977, 106-107) observed that

share splits sometimes are regarded as means of alteringmarket prices of shares to bring them into a more "popular"price level and so to "broaden" the market for the share,which presumably implies a higher price.

Nobody has yet explained why this occurs, but it can be

easily explained by using supply and demand. There is a market

for shares of stock in the company. After the split, brokers

can sell the stock more easily to unknowledgeable investors.

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Because unknowledgeable investors do not understand stock

splits, at least some brokers tell customers that all the

customers need to know is that before, they would have had to

pay some price (say, sixty dollars per share), but now they can

buy the same number of shares in the same company for less

money. Second, whether or not the broker takes that approach

with a customer, it is easier for a broker (read salesman) to

sell a stock for thirty dollars than it is to sell a stock for

sixty dollars because the investor has less total money at risk

at the lower price. The result is that brokers actions to sell

post-split shares to customers move the post-split shares

demand curve outward, thereby increasing the price.

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Appendix

The Importance of the Drift

Several authors have given reasons why the drift is

important.

! Explanation of the anomaly is of interest for threereasons. First, it could resolve the conflicting resultsamong studies of earnings announcements. Second,explanation of the anomaly could provide evidence on theperformance of the two-parameter model 4 as a vehicle fordescribing the determination of securities' expectedreturns or on the appropriateness of the market portfolioused as a proxy for aggregate wealth. Third, it suggestscaution in designing experiments involving earnings ordividend yields (i.e., ratios of earnings and dividends pershare to share price) as independent variables and excessreturn as the dependent variable, because these experimentsare sensitive to model misspecification and can be expectedto produce anomalous evidence (Ball 1978, 104-105).

! Whatever is its intrinsic importance, investigation of thepost-earnings-announcement drift anomaly gains interestfrom the fact that it combines in one problem severalvexing conceptual, institutional, and econometricquestions. These include such issues as computing"correct" abnormal returns, the size effect, thedifferences between measured returns and "true" returns(based on underlying equilibrium prices), anomaliesresulting from different compounding methods, alternativeearnings expectation models, and the specification and

interpretation of tests of market efficiency (Marais 1989,46-47).

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challenges to the EMH (see Ball, 1992 and Lev and Ohlson,1982). (Hew, Skerratt, Strong, and Walker 1996, 283).

! Post-earnings announcement drift, the phenomenon wherestock prices continue to drift in the direction of theinitial price response to an earnings announcement, is oneof the most prominent and perplexing market anomaliesdocumented in the accounting literature (Collins and Hribar2000, 102).

The reason why post-earnings announcement drift is soanomalous is the lack of a coherent theory to fit theempirical facts (Collins and Hribar 2000, 120).

! ... post-earnings-announcement drift ... remains one of themost puzzling anomalies in accounting- and financial-economics-based tests of capital market efficiency withrespect to earnings information. Ongoing research studiescontinue the search for explanations, but thus far thepost-earnings-announcement drift anomaly has defied allattempts at rational explanation (Nichols and Wahlen 2004,284).

Since the drift anomaly is so important, it has attracted a

great deal of research effort. Table 1 contains a partial list

of the published studies which address post-earnings-

announcement drift in some fashion, although not uniformly

calling it by that terminology.

Ball (1992, 319) stated:

Based on the number of published papers which deal with thephenomenon, and on the implications of the phenomenon, it

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appears that gaining an understanding of the cause of thephenomenon is worthwhile.

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Table 1

List of Some Studies Which AddressPost-Earnings-Announcement Drift (PEAD)

Ball and Brown (1968)Beaver (1968)Breen (1968)Nerlove (1968)Nicholson (1968)Latan, Tuttle, and Jones (1969)Beaver, Kettler, and Scholes (1970)Jones and Litzenberger (1970)Latan, Joy, and Jones (1970)Litzenberger, Joy, and Jones (1971)Ball and Watts (1972)Brown and Kennelly (1972)Qualls (1972)Black (1973)Jones (1973)Black and Scholes (1974)Deakin, Norwood, and Smith (1974)Latan, Jones, and Rieke (1974)Foster (1975)Basu (1977)Brown, Finn, and Hancock (1977)

Foster (1977)Joy, Litzenberger, and McEnally (1977)Latan and Jones (1977)Ball (1978)Basu (1978)Brown (1978)Watts (1978)Brown (1979)Joy and Jones (1979)Latan and Jones (1979)Beaver and Landsman (1981)

Bidwell and Riddle (1981)Reinganum (1981)Lev and Ohlson (1982)Rendleman, Jones, and Latan (1982)Chambers and Penman (1984)Foster, Olsen and Shevlin (1984)

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Jones, Rendleman, and Latan (1984)Easton (1985)Jones, Rendleman, and Latan (1985)Rosenberg, Reid, and Lanstein (1985)Kormendi and Lipe (1987)Rendleman, Jones, and Latan (1987)Chari, Jagannathan, and Ofer (1988)Bernard and Thomas (1989)Easton and Zmijewski (1989)Freeman and Tse (1989)Lev (1989)Bernard and Thomas (1990)Abarbanell and Bernard (1992)Affleck-Graves and Mendenhall (1992)Ball (1992)Bartov (1992)Ball, Kothari, and Watts (1993)Bhushan (1994)Booth, Kallunki, and Martikainen (1996)Hew, Skerratt, Strong, and Walker (1996)van Huffel, Joos, and Ooghe (1996)Bernard, Thomas, and Wahlen (1997)Brown (1997)Calegari and Fargher (1997)Soffer and Lys (1999)Mendenhall (2002)Riahi-Belkaoui (2002)

Asthana (2003)Liu, Strong, and Xu (2003)

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Figure 1

A Pictorial Representation of Post-Earnings-Announcement Drift

t=0 t=1

Pricerelativeto themarket

Time

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Figure 2Pictorial Proof that the CAPM Price is Wrong

PriceRelativeto theMarket

t = 0Point A Point B Point C

Timet > 0

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Figure 3A Model That Works

Price

Quantity

MarketPrice

S

D

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Figure 5

Isolation of Points Selected in Figure 4

t=0 t=1

Pricerelativeto themarket

Time

JK

L

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Figure 6

Undoing Transformation of Points in Figure 5

t=0 t=1

Price

Quantity

JK

L

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Figure 7

Price Determination of First Point on PEAD

t=0 t=1

Price

Quantity

J

KL

D0

S0

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Figure 8

Price Determination of Second Point on PEAD

t=0 t=1

Price

Quantity

J

KL

D0

S0

D1

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Figure 9

Price Determination of Third Point on PEAD

t=0 t=1

Price

Quantity

J

KL

D0

S0

D1

S1

D2

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