1. Introduction
We investigate whether post-earnings announcement drift is associated with investor inertial behavior under a directional trend in market sentiment in the Korean stock market (KSE). Post-earnings-announcement drift (henceforth, PEAD) is defined as the anomalous stock price behavior in a capital market in which stock price moves continuously with directional unexpected earnings even after the earnings information is announced [
1,
2]. Given that the PEAD phenomenon is generally explained by a delayed stock response due to investors’ underreaction to earnings news (i.e., unexpected earnings), we focus on investor inertia, a type of cognitive bias in psychology, as an influential factor in PEAD. Market sentiment generally represents the market mood at any given time. Among investors in a practical field, it is referred to as stock valuation or investment strategy. It is known that higher (lower) sentiment indicates that the overall market state is more (less) optimistic. According to the literature on investor inertia, investors tend to procrastinate their decision making and retain their initial decisions by relying on existing information, and this tendency is known to be pronounced under a stable environment [
3]. In physics, inertia is defined as the property of an object’s resistance to change in velocity, which is also called Newton’s first law. That is, due to inertia, an object will continue to stay in uniform motion unless an external force is applied, making it change its course or speed. Understanding investors’ inertia in a capital market is important because it enables us to address critical issues related to the inefficient market (i.e., PEAD) and their role in shaping stock prices for securities investors hold [
4,
5]. The following article clearly presents a tendency for investor inertia in Korea. “…the law of inertia in psychology is defined as an investor’s vague belief that a current psychological state or situation will remain unchanged for several periods. For instance, four years ago, many experts stressed that investors should sell real estate in provincial cities and buy properties in metropolitan areas while announcing a negative forecast for apartment prices in rural areas. However, what happened to the markets? The price of real estate in provincial cities soared sharply, and on the contrary, real estate prices in metropolitan areas plummeted dramatically. Why do these results occur? The reason is that the law of inertia influences experts’ and investors’ beliefs. At the time, the price of local apartments had been continuously low for about five years, and thus, this situation made both experts and investors overconfident that it would be too difficult to rebound….” Investors’ psychology, “the law of inertia” [
6].
In this context, we postulate that a continuation of directional market sentiment induces investor inertial behavior and hypothesize that PEAD is systematically related to investors’ underreaction, which is attributable to investor inertia under the market sentiment with trend. Allowing us to be able to predict future stock returns by showing a continuation of stock price movement, PEAD resembles the price momentum documented in finance literature. However, those two phenomena are different in that while price momentum allows investors to obtain the hedge returns based on past returns information [
7,
8,
9], PEAD allows investors to obtain the hedge returns based on unexpected earnings information in the earnings announcement period [
1,
10]. In this paper, we focus on PEAD analysis covering investors’ underreaction to earnings information due to investor inertia in the situation in which market sentiment has a directional trend. That is, when investors lie in the market mood which changes with a trend of increase or decrease, investor inertial behavior occurs, which leads to the delayed stock price reaction. To be specific about the relation between PEAD and change in market sentiment in connection with investor inertia, investors are likely to expect the current market state to last going forward and adhere to their prior belief based on the current state of the market sentiment. To delineate our prediction in terms of market pricing, if market sentiment has continuously moved upward from the previous period, then considering a target firm over-valued for a certain period of time, investors are likely to ignore especially positive unexpected earnings that incorporate information about future earnings increase (that’s where the inertia comes in). However, as investors understand the implication of positive unexpected earnings as time goes by, stock price reflects such investors’ behavior and thus stock price drift occurs on positive unexpected earnings. Conversely, if the market sentiment has continuously moved downward from a previous period, stock price drift occurs on negative unexpected earnings.
While prior studies document that stationary market sentiment plays a crucial role in moving share prices in the stock market [
4], our intuition provides a new perspective on the effect of market sentiment on the stock market by suggesting that moving sentiment over the earnings announcement periods also influences market pricing aside from the level of market sentiment at a specific point in time.
This is rather practically evident. Most articles of news media on market sentiment often deliver the information about the change in market sentiment (i.e., trend) with investors’ behavior also forecasted accordingly. Also, technical analysis in finance means investors tend to forecast future in the basis on market trend, rather than the level of market state. It implies that the information of market sentiment trend is worth it for investors to make decisions. In this context, we posit it is based on a change in market state by the time that investors take actions, and in such respect, we revisit the relation between stock price drift and market sentiment, indicating discriminative analysis from previous research.
The Korean stock market is characterized by the relatively high participation of individual investors among the emerging markets, where institutional investors are major market players [
11]. Since individual investors are likely to be affected by the market sentiment [
12], the Korean stock market is generally considered sensitive to the market sentiment.
However, very little research has examined the relation between market sentiment and investor responsiveness to earnings news in Korea. Moreover, relative to the level of market sentiment at a specific point in time, studies on the effect of the market sentiment with trend on market inefficiency are absent, as far as we know.
Using quarterly data from 2002 Q4 to 2017 Q4 in the Korean stock market (Korea Stock Exchange), we conduct portfolio tests by upward trend and downward trend in market sentiments and run a regression analysis. We employ the composite index suggested by a prior study [
13] as a proxy for market sentiment. We find that the magnitude of drift in stock price subsequent to an earnings announcement is significantly related to the market sentiment with trend over two periods prior to and following an earnings announcement. More specifically, for an upward (downward) trend in market sentiment, PEAD occurs on positive (negative) unexpected earnings, and these results are robust after controlling for the effect of the state of the market sentiment at a specific point in time (i.e., both prior to and following earnings announcements). Additionally, we show that the subsequent abnormal return following an earnings announcement is incrementally lower when the prior-sentiment is higher but indifferent to following-sentiment. Overall, our findings suggest that the stock price drift is affected by the investor inertia under a continuation of directional market sentiment as a proxy for a stable environment, not subsuming the effect of market sentiment in a period following earnings announcements per se.
By linking post-earnings announcement drift to the market sentiment with trend, our study provides quite different insights from prior studies into market anomalies examining subsequent abnormal returns relative to the level of market sentiment at a specific point in time. This paper contributes to the academic and practical accounting fields in several ways. First, our research findings add another determinant of PEAD to the literature by documenting the relation between PEAD and investor inertial behavior. Second, by investigating how an investor’s cognitive bias (i.e., problem of inertia) affects abnormal returns in earnings-based trading strategies, our study is useful to professional investors who try to capture abnormal returns from market mispricing. Third, our findings are also valuable to academic fields interested in understanding stock price behavior and estimating a firm’s intrinsic value.
This paper is organized as follows. In
Section 2, we discuss the background and develop the hypothesis. The methodology, including sample selection, variable definitions, and model specification, is presented in
Section 3. We provide our empirical test results in
Section 4. Finally,
Section 5 concludes the paper.
4. Empirical Results
4.1. Descriptive Statistics and Correlation Analysis Results
Table 2 reports the descriptive statistics for all test variables. Market sentiment variables (PSENT, ASENT, DSENT, and CSENT) show their distribution based on all firm-quarter observations. The mean value of 0.532 on DSENT means that approximately 53% of sample experiences the upward shift of market sentiment at the next quarter. The gap between the mean and median as well as the high standard deviation of the main variable, SUE, and the other control variables such as FOR, FOLLOW, and VOLATI indicate the skewed distribution of the variables. To eliminate any potential bias caused by their skewness, we use the decile rankings of all the independent variables in the regression analysis except for market sentiment variables.
Next,
Table 3 represents the results of the correlation analysis for the main variables. These results show that unexpected earnings (SUE) and cumulative abnormal returns (SAR60 and MAR60) are highly correlated (ρ of Spearman = 0.089 and 0.095, respectively), indicating that there exists a drift in stock price related to earnings surprise (shock). Note that both market sentiment variables, PSENT and ASENT, are negatively correlated with size-adjusted abnormal returns (MAR60) and not correlated with market-adjusted abnormal returns (MAR60). However, our key variables, DSENT and CSENT (i.e., the change in market sentiment variables), are positively associated with MAR60 but negatively associated with SAR60. The correlation of Market sentiment variables, PSENT and ASENT, and SUE is not significant, except that ASENT is negatively correlated with SUE. Similarly, both DSENT and CSENT are not correlated with SUE.
Overall, the results of the correlation analysis between the change in market sentiment and subsequent abnormal returns following earnings announcements are mixed. However, the results are distinguishable from those on the level of market sentiment, indicating that the effect of the change in market sentiment on subsequent abnormal returns does not subsume the effect of the level of market sentiment at a specific point in time. To verify our hypothesis in the next section, we conducted a regression analysis on the model controlling for a variety of factors affecting abnormal returns.
4.2. Regression Analysis Results
Table 4 provides the regression results for our hypothesis regarding the effects of changes in market sentiment. We measured changes in market sentiment in two ways, as DSENT and CSENT. Where, DSENT denotes the indicator variable on whether market sentiment increases over two quarters (t − 1 and t) and CSENT denotes the change value in the market sentiment over two quarters (t − 1 and t). Our interesting variables are the interaction terms, DSUE*DSENT in Panel A and DSUE*CSENT in Panel B. The coefficient of DSUE*DSENT on size-adjusted abnormal returns (SAR60) is positive and significant at the 10% level (0.0168, t-statistic = 1.85). Moreover, the coefficient of DSUE*CSENT on SAR60 is also significantly positive at the 1% level (0.0196, t-statistic = 2.84). These results are more robust to the estimation by market-adjusted abnormal returns (MAR60). Specifically, the coefficients of DSUE*DSENT on SAR60 or MAR60 are all positive and significant at the 1% level (t-statistic = 4.10 and 3.66, respectively).
Notably, the results hold after controlling for the effect of market sentiment at a specific point in time, prior-sentiment (PSENT) and following-sentiment (ASENT).
Since the coefficients of DSUE are positive and significant, these results indicate that the magnitude of PEAD incrementally increases with an (upward) change in the market sentiment, consistent with our hypothesis. Overall, our findings imply that the incremental increase in the magnitude of PEAD is attributable to investors’ inertia, which leads them to underreact to earnings information, in line with the direction of change in market sentiment. It is not the effect of mispricing on the market sentiment at a specific point in time.
Prior to the adjustment of such a potential problem through the statistical method, we checked the degree of heteroscedasticity and serial-autocorrelation by using the Durbin Watson [
51] test. The DW value of the Durbin Watson test ranges from 0 to 4. The value near 0 implies positive serial autocorrelation and that near 4 implies negative serial correlation. [
52,
53]. The test results on our main hypothesis in
Table 4 show that DW-statistics present the value between 1 and 2 (1.884, 1.881), indicating the existence of slightly positive auto-correlation among residuals. Finally, to control some estimation biases since our data, as panel data, entail the cross-sectional or time-serial correlation in error term, we include dummy variables for year and industry in the model. Furthermore, all regression models use t-statistics based on robust standard errors clustered at firm level [
48].
4.3. Portfolio Drift Test
While the regression analysis results provide the effect of the change in market sentiment on the stock price drift, a portfolio drift test in this section suggests the economic significance of the accounting earnings information (i.e., SUE) and mispricing due to investors’ inertia under the change in market sentiment.
Table 5 represents the average abnormal returns on each portfolio, conditional on both SUE quintiles and the change in the market sentiment state (Upward Shift, Downward Shift). Upward (Downward) shifts happen when the market sentiment rises (falls) between the current and the previous quarter. Panel A presents the test results based on the cumulative size-adjusted abnormal returns (SAR60) and Panel B presents the test results based on the cumulative market-adjusted abnormal returns (MAR60).
Given that PEAD shows the magnitude of the gap between cumulative abnormal returns on positive and on negative unexpected earnings, we predict that hedge returns for the portfolio of 5-1, which is the abnormal returns from the investment strategy that longs the highest portfolio (SUE5) and shorts the lowest portfolio (SUE1), is higher in the Upward Shift group than in the Downward Shift group. Consistent with the regression analysis results but only in the test based on market-adjusted abnormal returns (panel B), the result shows the hedge returns for a portfolio of 5-1 when the market sentiment shifts upwardly are higher than those when the market sentiment shifts downwardly. Specifically, hedge returns for stocks in a portfolio with an Upward Shift are 6.93% (t-statistic = 8.19) of MAR60. It is larger than the hedge returns with a Downward Shift (3.49% of MAR60) and those with market sentiment—unconditioned portfolio (4.80% (t-statistic = 9.35) of MAR60). These results indicate that the extent of PEAD systematically differs by the change in market sentiment and increases with the upward change in market sentiment. However, such an argument is not evident in size-adjusted abnormal return (SAR60)—based test in Panel A, because the higher PEAD with upward shift of market sentiment occurs only in the two lowest SUEs and by and large, is not significant in high SUEs. Considering the portfolio drift is testable regardless of any other factors on PEAD, this result is acceptable to such a degree that our hypothesis is partially supported. Finally, our findings suggest that understanding accounting-based earnings information beforehand is important in order to avoid suffering from mispricing due to investor inertia on market sentiment.
4.4. Additional Test: Asymmetric PEAD
According to Mian and Sankaraguruswamy [
44], market sentiment differently affects the magnitude of PEAD by the level of unexpected earnings. They argue that when market sentiment is high, investors overreact to positive unexpected earnings but underreact to negative unexpected earnings. By contrast, when market sentiment is low, investors overreact (underreact) to the negative (positive) unexpected earnings. Accordingly, we expect the effect of the change in market sentiment on the magnitude of PEAD to also be asymmetric by the level of unexpected earnings. However, the results show that PEAD due to investor inertia is asymmetric by the level of unexpected earnings. We include the changes in the market sentiment conditional on positive and negative unexpected earnings as independent variables and regress them on subsequent abnormal returns following an earnings announcement (i.e., SAR60 and MAR60).
The results are presented in
Table 6. Panel A and Panel B represent the regression results on DSENT and CSENT, respectively. The coefficients of positive unexpected earnings (DSUE(Pos)) and the interaction terms of market sentiment conditional on the positive unexpected earnings (DSUE(Pos)*DSENT or DSUE(Pos)*CSENT) are all statistically significant on the abnormal returns (SAR60 and MAR60). While the coefficient of the negative unexpected earnings (DSUE(Neg)) and interaction terms of market sentiment conditional on the negative unexpected earnings (DSUE(Neg)*DSENT or DSUE(Neg)*CSENT) are not significant. Only the terms, DSUE(Neg) and DSUE(Neg)*CSENT, regressed on MAR60 are significant, as presented in panel B. Collectively, the effect of the change in market sentiment on PEAD varies with the direction of unexpected earnings, but the significance of those results is weak. This implies that stock price drift due to underreaction to earnings information with regard to the investor inertia is relatively dominant for positive unexpected earnings.
To confirm this asymmetric PEAD on unexpected earnings, we examine the stock returns for each cumulative trading day following the earnings announcement date with a 10-day interval. In this test, we use portfolios with the highest and the lowest SUE to more clearly identify the relation between unexpected earnings and the change in market sentiment. As denoted in panel B of
Table 7, the market-adjusted abnormal returns only on positive unexpected earnings (SUE5) are incrementally high for portfolios with an upward change in market sentiment, whereas those of negative unexpected earnings (SUE1) does not show higher drift magnitude due to the change in market sentiment. For 60 trading days following the earnings announcement, cumulative market-adjusted returns (MAR60) on SUE5 increase to 3.75% from 3.21% when conditional on an upward shift in the market sentiment, indicating that the upward change in market sentiment affects the magnitude of PEAD on positive unexpected earnings. However, for our sample, cumulative size-adjusted returns on unexpected earnings (SUEs) seem to be unconnected with PEAD due to a shift in market sentiment. These results are all but in line with those of the regression analysis in Panel A of
Table 6, which shows the estimates of unexpected earnings (SUEs) and the interaction terms of DSENT are not significant or statistically weak. Overall, the results support in part the argument that the magnitude of PEAD on earnings information with regard to the investor inertia exists asymmetrically with the direction of unexpected earnings.
4.5. Additional Test: The Effect of Prior-Sentiment and Following-Sentiment on PEAD
This section discusses whether the extent of the PEAD is systematically different by the market sentiment during pre- and post-earnings announcement periods. Since the change in market sentiment is measured as the difference between prior-sentiment level and following-sentiment level, it is possible that the magnitude of the drift in stock price by the change in market sentiment subsumes the independent effect of prior-sentiment or following-sentiment. Moreover, previous studies have documented the market sentiment effect on stock reaction or long-term stock returns in terms of prior-sentiment, as delineated in
Section 2.
However, there remains a question of whether investors’ optimism due to high market sentiment following an earnings announcement (i.e., following-sentiment) significantly influences stock price drift regardless of the level of prior-sentiment. If investors pass over the information implied in prior-sentiment or prior mispricing and thus naively form their belief based on the following-sentiment when they predict future performance, then their higher optimism due to high following-sentiment may cause the higher magnitude of stock price drift.
Thus, we conjecture that the relation between the magnitude of PEAD and market sentiment varies with not only the prior-sentiment but also the following-sentiment. More specifically, we predict that while the magnitude of PEAD decreases with prior-sentiment, the magnitude of PEAD increases with following-sentiment. To test our conjecture, we implement the following regression models. First, we test the incremental effect of prior-sentiment (PSENT) on abnormal returns while controlling for following-sentiment (ASENT) and the other determinants of PEAD:
Next, we also test the incremental effect of following-sentiment (ASENT) on abnormal returns while controlling for prior-sentiment (PSENT) and the other determinants of PEAD:
We intersect the unexpected earnings variable (DSUE) with the market sentiment variables (PSENT or ASENT) to capture the incremental effect of market sentiment on PEAD. If the state of market sentiment for pre (post)-earnings announcement periods incrementally affects PEAD, the coefficient of DSUE*PSENT is significantly negative, and that of DSUE*ASENT is significantly positive.
Table 8 presents the regression results. Panel A reports the results for the effect of prior-sentiment. The high prior-sentiment conditional on DSUE has mitigating effects on abnormal returns, as denoted by the significant negative coefficient of DSUE*PSENT (−0.0299, t-statistic= −4.37), indicating that prior-sentiment lowers the magnitude of PEAD. On the contrary to this, for the following-sentiment in Panel B, DSUE*ASENT is positive and statistically significant (0.0140, t-statistic = 2.20). The test results in Panel B are also similar with those in Panel A. These results imply that only following-sentiment is an influential factor on PEAD and not prior-sentiment.
4.6. Additional Test: The Effect of the Change in Market Sentiment on ERC(Earnings Response Coefficient)
Since PEAD is attributed to the investors not having a sufficient reaction to earnings news at the announcement date, in this section we examine the earnings response coefficient by the change in market sentiment. If investor inertia under the market sentiment change truly affects the extent of the stock price response, investors should respond less to earnings information when the market sentiment is rising continuously around an earnings announcement period.
To address our conjecture, we conduct a regression model as follows.
where, AR3 represents cumulative size-adjusted abnormal returns (SAR (−1, +1) measured over the three trading days around the quarterly earnings announcement date (0). Other variables are identical to the main models in this study. Still, the interaction term (DSUE*CHSENT) captures the incremental effects of the change in market sentiment between pre- and post-earnings announcement periods on abnormal returns, conditional on the SUE decile rankings. If investors’ response to earnings information lowers due to investor inertia when the market sentiment upwardly changes, we expect the slope coefficient of the interaction term to be significantly negative.
Table 9 provides evidence that the change in market sentiment has no incremental effect on stock price reaction around the earnings announcement period. As presented, the coefficients of DSUE*CHSENT are negative but not statistically significant, while the coefficient of DSUE is significantly positive. This indicates that investors’ response to the earnings announcement may be less when market sentiment changes, supporting the investor inertia hypothesis, but the extent is not statistically significant.
5. Conclusions
This study investigated whether the magnitude of stock price drift is systematically different by the change in market sentiment. Positing that the continuation of the directional market sentiment influences investors’ inertial behavior, which causes an underreaction to earnings information, we then conjectured that the post-earnings-announcement drift is systematically associated with the change in market sentiment. We employed the composite index suggested by Kim and Byun [
13] as a proxy for market sentiment. To test our hypothesis, we conducted a portfolio drift test and a regression analysis using financial data from 2002 Q4 to 2017 Q4 in the Korean stock market (KSE).
Our results showed that the subsequent abnormal returns following an earnings announcement incrementally increase with the change (especially upward shift) in the market sentiment. Note that this result holds even after controlling for the effect of prior- or following-sentiment on abnormal returns. Our findings suggest that the change in market sentiment is significantly related to the PEAD, which results from the market’s underreaction due to investor inertia. However, this result does not subsume the effect of prior- or following-sentiment on PEAD. Further, we showed that this result is significant just for positive unexpected earnings, indicating asymmetric PEAD due to investor inertia in the direction of unexpected earnings.
Our paper is distinctive from previous research in that we documented that PEAD is affected by the change in market sentiment, just not market sentiment for a specific point in time (i.e., prior-sentiment or following-sentiment). Our findings are useful for researchers as well as professional investors interested in understanding stock price behavior from intrinsic firms’ value and trying to capture abnormal returns from market mispricing. With respect to this, we emphasize on understanding of accounting earnings information which implicitly signals future earnings.
Conclusively, by linking PEAD as one market anomaly with investor inertial behavior under changing market sentiment, our findings shed light on the relation between investor’s cognitive biases in a certain environment and market anomalies. In this respect, we proposed some thesis on differential inertia effect by investor sophistication in a capital market. Specifically, prior research has documented that foreign investors are relatively superior to other investors in the emerging market. Thus, we suggest that whether they play a role in mitigating indeed PEAD magnitude due to inertia behavior is feasible as future research.
To summarize, investors are biased toward the conventional belief based on market sentiment when processing earnings information. Where, to explain market inefficiency under market sentiment change, we adopted investor inertia concept. However, ultimately what we emphasize is the role of accounting information content which involves the information about future earnings to improve market efficiency. In this respect, we suggest that properly understanding the accounting information is the instrumental factor that enables the capital market to be sustainable with the stock market working efficiently.
Most of the behavioral finance-related literature tests the hypothesis by using a single factor or multi-factors model and forming portfolios based on the explanatory variable level [
54,
55]. However, we consider that analyzing by regression model in an attempt to test the PEAD phenomenon, even though latently caused by investor cognitive bias, makes the internal validity of our research more enhanced. Nevertheless, we acknowledge such a limitation of our paper and encourage the extended research to use a modelling framework (i.e., behavioral model) in order to intensify our thesis.