Unsophisticated Arbitrageurs and Market Efficiency: Overreacting to a History of Underreaction?

Abstract

Prior research has documented that arbitrage activity significantly reduces or eliminates stock market anomalies. However, if anomalies arise due to unsophisticated investors’ behavioral biases, then these same biases can also apply to unsophisticated arbitrageurs and thereby disrupt the arbitrage process. Consistent with a disruption in the arbitrage process for the post‐earnings announcement drift anomaly, I document that the historically positive autocorrelation in firms’ earnings announcement news has become significantly negative for firms with active exchange‐traded options. For these easy‐to‐arbitrage firms, the firms in the highest decile of prior earnings announcement abnormal return (prior earnings surprise), on average, underperform the firms in the lowest decile by 1.59% (1.43%) at their next earnings announcement. Additional analyses are consistent with investors learning about the post‐earnings announcement drift anomaly and overcompensating. This study suggests that unsophisticated attempts to profit from a well‐known anomaly can significantly reverse a previously documented stock return pattern.

Non‐GAAP Earnings Disclosure in Loss Firms

“…The negative association between non‐GAAP earnings surprises and future earnings announcement returns is also consistent with more general evidence that post‐earnings announcement drift has reversed (i.e., investors overreact instead of underreact to earnings surprises) in recent years (Milian [], Veenman and Verwijmeren []).…”

“…Months before and after this period are dropped out of the investigation because too few observations are available to construct the loss converters portfolio. 40 The negative association between non-GAAP earnings surprises and future earnings announcement returns is also consistent with more general evidence that post-earnings announcement drift has reversed (i.e., investors overreact instead of underreact to earnings surprises) in recent years (Milian [2015], Veenman and Verwijmeren [2018]).…”

The Dog that Did Not Bark: Limited Price Efficiency and Strategic Nondisclosure

“…The first is that limits on investors' attention prevent them from fully understanding the implication of nonguidance for firm value. Inattention can simply mean that investors are not aware of the information because of their limited capabilities to acquire and process information (e.g., deHaan, Shevlin, and Thornock [2015], Milian [2015], Blankespoor, deHaan, and Marinovic [2020]). Inattention could also reflect "limited strategic thinking."…”

Off-Exchange Trading and Post Earnings Announcement Drift

“…Relatedly, Johnson and Schwartz (2000), Richardson et al (2010), and Chordia et al (2014) find that mispricing related to drifts has declined in recent years, especially among liquid stocks. In fact, there are indications that arbitrage activity has become so aggressive that prices overshoot their efficient levels in some cases (Milian 2015 As discussed earlier, almost all retail marketable (i.e. market or marketable limit) orders are routed by retail brokerages directly to OTC wholesale dealers.…”