SystemTrader
StocksIntermediateEvent-Driven

Earnings Momentum Strategy

Buy stocks with positive earnings surprises, sell those with negative surprises. Exploits the market's sluggish reaction to earnings news—the "granddaddy of underreaction events."

Signal
SUE (Earnings Surprise)
Lookback
4-8 Quarters
Holding
1-3 Months
Rebalance
Quarterly

Overview

The earnings momentum strategy exploits one of the most robust anomalies in finance: the Post-Earnings Announcement Drift (PEAD). First documented by Ball and Brown in 1968, PEAD shows that stock prices continue to drift in the direction of the earnings surprise for weeks or months after the announcement.

The selection criterion is Standardized Unexpected Earnings (SUE)—the difference between actual and expected earnings, normalized by historical volatility. Stocks with high positive SUE (beat expectations) tend to continue rising, while stocks with negative SUE (missed expectations) continue falling.

Eugene Fama called PEAD the "granddaddy of underreaction events"—one of the few anomalies he admits is robust. The drift suggests markets process earnings information slowly, creating a systematic opportunity for patient investors.

Key Insight

Beats Keep Beating
Positive surprises predict continued gains
Misses Keep Missing
Negative surprises predict further declines
Slow Information Processing
Markets take time to fully digest earnings

SUE Formula

SUE = (E - E') / σ

E = Current EPS
E' = EPS 4 quarters ago
σ = Std dev of surprises

Strategy

Long top decile (SUE > 1.5)
Short bottom decile (SUE < -1.5)

Key Insight

Stocks with high positive SUE (beat expectations significantly) tend to continue drifting up. This "PEAD" effect persists 1-3 months.

Research

Post-earnings announcement drift is one of the most studied and replicated anomalies in finance, with research spanning over 50 years from Ball & Brown (1968) to modern text-based approaches.

The Mathematics

In Plain English

The math behind this strategy is straightforward. Here's what you're actually doing:

  1. 1
    Get the most recent quarterly EPS (E_i) for each stock
  2. 2
    Get the EPS from 4 quarters ago (E'_i) for comparison
  3. 3
    Calculate unexpected earnings: Surprise = E_i - E'_i
  4. 4
    Calculate standard deviation of surprises over past 8 quarters (σ_i)
  5. 5
    Compute SUE: Standardized Unexpected Earnings = Surprise / σ_i
  6. 6
    Rank all stocks by SUE and construct portfolios
  7. 7
    Buy top decile (highest SUE), sell bottom decile (lowest SUE)

That's it. The formulas below just express this process precisely.

Technical Formulas

1
Standardized Unexpected Earnings (SUE)

Formula
SUE_i = \frac{E_i - E'_i}{\sigma_i}

Where E_i is the most recently announced quarterly EPS, E'_i is the EPS from 4 quarters ago, and σ_i is the standard deviation of (E_i - E'_i) over the last 8 quarters.

2
Alternative: Analyst-Based SUE

Formula
SUE_i = \frac{E_i - \bar{E}_i^{forecast}}{\sigma_i}

Instead of using seasonal comparison (4 quarters ago), use the mean analyst EPS forecast as the expectation. This captures surprise relative to market expectations.

3
Portfolio Construction

Formula
R_{portfolio} = R_{top\ decile} - R_{bottom\ decile}

Construct a dollar-neutral portfolio: go long stocks in the top SUE decile and short stocks in the bottom SUE decile. Hold for 1-3 months.

Why Standardize?Note

Raw earnings surprises vary widely in magnitude across firms. A $0.01 surprise for a $0.05 EPS firm is huge; for a $5.00 EPS firm, it's noise. Dividing by historical volatility normalizes the signal across all stocks.

Seasonal ComparisonNote

Comparing to 4 quarters ago (same quarter last year) accounts for seasonality in earnings. Retailers have Q4 peaks, for example. This provides a more meaningful baseline than sequential quarters.

PEAD DeclineNote

Research shows PEAD has weakened over time, possibly due to faster information dissemination, more algorithmic trading, and declining earnings persistence. The strategy works better for smaller, less-followed stocks.

Strategy Rules

Universe Selection

  1. Start with a broad universe (e.g., Russell 3000 or S&P 1500)
  2. Require minimum 8 quarters of earnings history for SUE calculation
  3. Exclude stocks with negative book value or extreme penny stocks
  4. Ensure sufficient liquidity (average daily volume > $1M)
  5. Focus on smaller, less-followed stocks where PEAD is stronger

SUE Calculation

  1. 1Calculate quarterly EPS surprise: Current EPS - Same quarter last year EPS
  2. 2Compute 8-quarter rolling standard deviation of surprises
  3. 3Divide surprise by standard deviation to get SUE
  4. 4Handle special items: Use adjusted EPS when available
  5. 5Update calculations within 1-2 days of earnings announcement

Portfolio Construction

  1. Rank all stocks by SUE from highest to lowest
  2. Long position: Top 10% (decile 10) with highest SUE
  3. Short position: Bottom 10% (decile 1) with lowest SUE
  4. Equal-weight positions within each decile
  5. Long-only variant: Only buy top decile, skip shorting

Timing & Rebalancing

  1. 1Enter positions shortly after earnings announcement (1-2 days)
  2. 2Hold for 1-3 months (drift is strongest in first quarter)
  3. 3Rebalance quarterly as new earnings are announced
  4. 4Consider staggered entry across earnings season
  5. 5Exit before next earnings if holding through announcement is risky

Implementation Guide

Implementing earnings momentum requires access to timely earnings data and the ability to act quickly after announcements. The strategy is more data-intensive than price momentum but offers a distinct source of alpha.

1

Gather Earnings Data

You need historical quarterly EPS data for your universe. This includes actual reported EPS and, ideally, analyst consensus estimates for an alternative SUE calculation.

Tips
  • Free sources: SEC EDGAR filings, Yahoo Finance (limited history)
  • Paid sources: Compustat, FactSet, Bloomberg, Refinitiv
  • Need at least 8 quarters of history per stock
  • Use diluted EPS adjusted for special items when available
2

Calculate SUE for All Stocks

For each stock with sufficient history, calculate the Standardized Unexpected Earnings using the formula. Compare current quarter EPS to the same quarter one year ago.

Tips
  • Surprise = EPS_current - EPS_4quarters_ago
  • σ = standard deviation of surprises over last 8 quarters
  • SUE = Surprise / σ
  • Handle missing data: exclude stocks with gaps

Be careful with stock splits and share count changes. Use split-adjusted EPS.

3

Rank and Select Stocks

After each earnings announcement, rank all stocks by their SUE. Select the top decile (highest positive surprises) for long positions and bottom decile for short positions.

Tips
  • Update rankings as each stock reports (rolling basis)
  • Or wait until most stocks report and batch-process
  • Top 10% (decile 10) = long, Bottom 10% (decile 1) = short
  • Long-only: just buy top decile, equal-weighted
4

Execute Trades

Enter positions within 1-2 days of the earnings announcement. The drift begins immediately but continues for several weeks, so you don't need to trade in the first minutes.

Tips
  • Avoid the immediate post-announcement volatility (first hour)
  • Use limit orders near the bid-ask midpoint
  • Equal-weight positions within each decile
  • Size positions based on total portfolio (e.g., 2-5% per stock)
5

Hold and Rebalance

Hold positions for 1-3 months. The drift is strongest in the first quarter after announcement. Rebalance quarterly as new earnings data arrives.

Tips
  • Monitor for news that might affect the thesis
  • Consider exiting before the next earnings announcement
  • Stagger entries across the earnings season for smoother returns
  • Track your SUE rankings vs. actual returns for validation

Data Requirements

This strategy requires timely access to earnings announcements and historical EPS data. While basic earnings data is free, comprehensive coverage for a large universe typically requires a data subscription. Consider starting with a smaller universe (e.g., S&P 500) using free data sources.

Helpful Tools & Resources

Earnings Data
Compustat, FactSet, Yahoo Finance
Analysis
Python/Pandas, R, Excel
Execution
Interactive Brokers, Schwab, Fidelity

Strategy Variations

Explore different ways to implement this strategy, each with its own trade-offs and benefits.

Analyst-Based SUE

Instead of comparing to EPS from 4 quarters ago, compare actual EPS to the mean analyst forecast. This captures surprise relative to market expectations rather than historical patterns.

Requires analyst estimate data (e.g., I/B/E/S).

Combined Price + Earnings Momentum

Combine SUE with price momentum. Select stocks that have both high earnings surprises AND strong recent price performance. Research shows these two signals provide independent information.

Chan, Jegadeesh & Lakonishok (1996) found both predict returns independently.

Revenue Surprise

Apply the same methodology to revenue instead of earnings. Revenue surprises are harder to manipulate and may provide a cleaner signal, especially for growth companies.

Useful for companies with volatile or negative earnings.

Small-Cap Focus

Concentrate on smaller, less-followed stocks where PEAD is strongest. Research shows the drift is larger for firms with low analyst coverage and high information uncertainty.

Higher transaction costs but larger potential alpha.

Earnings Quality Filter

Add an earnings quality screen (low accruals, cash flow confirmation) to filter out potential earnings manipulators. High-quality surprises may produce more reliable drift.

Combines PEAD with accruals anomaly research.

Consider combining multiple variations or testing them against your specific investment goals and risk tolerance.

Risks & Limitations

High(2)
Medium(3)
Low(1)
PEAD Decline Over TimeHigh

Research shows post-earnings announcement drift has weakened significantly since the 1990s. Faster information dissemination, algorithmic trading, and more sophisticated investors have reduced the anomaly. The strategy may produce lower returns than historical studies suggest.

Impact:
Data and Timing RequirementsHigh

The strategy requires timely, accurate earnings data. Delays in receiving or processing data reduce the opportunity window. Errors in EPS data (stock splits, restatements, special items) can corrupt the signal.

Impact:
Earnings Announcement VolatilityMedium

Stock prices are highly volatile around earnings announcements. Wide bid-ask spreads and rapid price movements can result in poor execution. The surprise direction may reverse quickly if guidance disappoints.

Impact:
Short-Selling ConstraintsMedium

The full dollar-neutral strategy requires shorting the bottom decile. Many stocks with negative earnings surprises may be hard to borrow, have high borrow costs, or be subject to short-sale restrictions.

Impact:
Transaction CostsMedium

Quarterly rebalancing across many stocks generates significant turnover. For smaller stocks where PEAD is strongest, transaction costs can be substantial and erode returns.

Impact:
Earnings Quality IssuesLow

Earnings can be managed or manipulated through accounting choices. A "surprise" driven by aggressive accounting rather than genuine performance may reverse. Accrual-based earnings are less reliable than cash-based.

Impact:
Understanding these risks is essential for proper position sizing and portfolio construction. Consider combining with other strategies to mitigate individual risk factors.

References

  • Chan, L.K.C., Jegadeesh, N. & Lakonishok, J. (1996). Momentum Strategies. Journal of Finance, 51(5), 1681-1713 [Link]
  • Bernard, V.L. & Thomas, J.K. (1989). Post-Earnings-Announcement Drift: Delayed Price Response or Risk Premium?. Journal of Accounting Research, 27, 1-36 [Link]
  • Bernard, V. & Thomas, J. (1990). Evidence That Stock Prices Do Not Fully Reflect the Implications of Current Earnings for Future Earnings. Journal of Accounting and Economics, 13, 305-341 [Link]
  • Ball, R. & Brown, P. (1968). An Empirical Evaluation of Accounting Income Numbers. Journal of Accounting Research, 6(2), 159-178 [Link]

Earnings momentum strategies involve risk of loss. The post-earnings announcement drift has declined over time and may not persist in the future. Past performance is not indicative of future results. This is educational content, not investment advice.

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