Insight Line—June 4, 2007

Casting dispersion on one widely held investment mantra is daring, but two at the same time borders on heresy. After decades of dominance, the efficient market hypothesis and the doctrine of “past performance is no indication of future returns” have come under attack in the halls of academia over the past few years. Ironically enough, the most recent challenge from researchers Owen Lamont and Andrea Frazzini arises from within two institutions noted for their faculty support of efficient market theory—Yale University and the University of Chicago.¹

Using historical data from the University of Chicago’s Center for Research in Security Pricing (CRSP)², Mr. Lamont and Ms. Frazzini construct a trading strategy centered on corporate earnings announcements in an attempt to prove a relatively straightforward hypothesis: when stock trading volume is predictably high, history suggests stock returns also will be predictably high.

At the heart of their study is a brilliantly simple trading rule. Specifically, at the beginning of every calendar month, stocks are assigned to one of two portfolios: the expected earnings announcers and the expected non-announcers. For guidance on which companies fell into which categories, they looked to the previous year’s Wall Street Journal and COMPUSTAT databases. The portfolios are market-cap weighted and are rebalanced each month. The strategy is to buy on the last day of the month all stocks announcing earnings in the next month and short every stock not expected to announce. They hold this portfolio until the last day of that month, and then form a new portfolio using the same rule for the next month, and so on.³

I find the results impressive.

The long (announcers) portfolio earns an average of 61 basis points of additional return per month over the short (non-announcers) portfolio and 42 basis points more than the general basket of stocks tracked by the CRSP, and does so with a highly favorable risk/reward profile. Furthermore, commingling the two into a long/short portfolio begets an even more favorable risk/return profile and generates an additional 9 basis points of return per month. Strikingly, as Lamont and Frazzini indicate, the long/short portfolio appears divorced from other widely known performance-driving factors such as market risk, the value factor, the size factor and the momentum factor.⁴ (A graphic representation of the yearly returns of the long/short portfolio from 1927- 2004 is presented below.)

Suffice it to say, according to efficient market theory such an anomaly could not exist. The theory would maintain that arbitrageurs would act to nullify the earnings announcement effect. But, as the researchers point out, while it appears arbitrage does have some effect, the informed (or sophisticated) investor has yet to fully counter the trading activity of the uninformed (unsophisticated) investor in reacting to earnings announcements.

And, as the authors note, the “smart money” has had 77 years to get it right.

While I position that this discovery in and of itself appears sufficient to suggest market inefficiencies can and do exist, within its core lies perhaps the greatest challenge to widely accepted investment theory.

You see, in studying the effect of earnings premium announcements on returns, the authors concluded that stocks that historically commanded higher volume and higher returns subsequently repeat the pattern of higher volume and higher returns in future years. “Looking at the difference between high volume concentration and low volume concentration stocks, it is striking that high volume concentration today predicts higher subsequent abnormal volume on announcing amounts and lower subsequent volume in non-announcing months,” [italics mine].⁵

In other words, with this one sentence, I suggest Lamont and Frazzini offer a serious challenge to another investment dogma: past performance is not an indicator of future returns. Granted, the possibility does exist that Lamont and Frazzini may have tortured the data long enough to get it to confess anything, which would render their results as nothing other than interesting conversation. Then again, if their work endures peer review and their conclusions prove independently repeatable, I believe they raise a serious challenge to the court of the efficient market.

¹ “The Earnings Announcement Premium and Trading Volume,” Owen Lamont and Andrea Frazzini, Working Paper Series #13090, National Bureau of Economic Research, Cambridge, MA, May 2007. http://www.nber.org/papers/w13090

² The Center For Securities Research and Pricing is a proprietary database of all listed and traded stocks on all U.S. exchanges. It is maintained at the University of Chicago Graduate School of Business for the use of academic pursuit related to equity pricing research. http://www.crsp.com/crsp/history.html

³ Lamont and Frazzini, page 8

⁴ Lamont and Frazzini, page 10

⁵ Lamont and Frazzini, page 19

This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its accuracy. The forecasts and opinions in this piece are not necessarily those of Van Kampen, and may not actually come to pass. Information in this report does not pertain to any Van Kampen product and is not a solicitation for any product.