Capital Gains Overhang and the Earnings Announcement Volume Premium

Abstract

This study examined why stocks that experience high abnormal trading volume around earnings announcements earn high returns. The high returns of high-volume stocks appear to be associated with selling pressure that is independent of fundamentals and that comes from a subset of investors who base their selling decisions on the magnitude of unrealized capital gains or losses. Supplementary evidence based on account-level data from a U.S. brokerage firm suggests extra selling pressure for stocks with large capital losses around earnings announcements. These patterns also suggest that the conventional interpretation of the disposition effect may not hold for stocks with large, unrealized capital losses around earnings announcements.

In this article, the authors examined a possible cause of the higher returns realized by stocks that experience high abnormal trading volume around earnings announcements, which they termed the earnings announcement volume premium (EAVP). The higher risk-adjusted returns for high-volume stocks suggest that sellers’ decisions are suboptimal and not based on fundamentals. All else being equal, such uninformed selling creates temporary downward pressure on a stock’s price that leads to higher abnormal returns as the price pressure dissipates. In searching for a determinant of such uninformed pressure, the authors drew on recent literature that suggests that certain investors’ sell decisions could be affected by unrealized capital gains or losses (i.e., capital gains overhang [CGO]) as predicted by the disposition effect.

The EAVP conditioned on the magnitude of CGO is both statistically and economically significant (as high as 10 percent a year). The authors also found a strong U-shaped relationship between the returns of high-volume stocks and CGO. This finding suggests that large unrealized losses, as well as large unrealized gains, prompt selling. The authors further refined the EAVP by conditioning it on both CGO and the content of earnings news. Finally, using account-level data from a U.S. brokerage firm, they found supplementary evidence of extra selling pressure for stocks with large capital losses around earnings announcements. The patterns they documented suggest that the conventional interpretation of the disposition effect may not hold for stocks with large unrealized capital losses around earnings announcements.