Anomalies and Financial Distress

This paper explores commonalities across asset-pricing anomalies. In particular, we assess implications of financial distress for the profitability of anomaly-based trading strategies. Strategies based on price momentum, earnings momentum, credit risk, dispersion, idiosyncratic volatility, and capital investments derive their profitability from taking short positions in high credit risk firms that experience deteriorating credit conditions. Such distressed firms are highly illiquid and hard to short sell, which could establish nontrivial hurdles for exploiting anomalies in real time. The value effect emerges from taking long positions in high credit risk firms that survive financial distress and subsequently realize high returns. The accruals anomaly is an exception it is robust amongst high and low credit risk firms as well as during periods of deteriorating, stable, and improving credit conditions. Asset pricing theories, such as the capital asset pricing model (CAPM) of Sharpe (1964) and Lintner (1965), prescribe that riskier assets should command higher investment payoffs. Existing theories, however, leave unexplained a host of empirically documented cross-sectional patterns in average stock returns, classified as anomalies. Specifically, price momentum, documented by Jegadeesh and Titman (1993), represents the strong abnormal performance of past winners relative to past losers. Earnings momentum, documented by Ball and Brown (1968), describes the outperformance of firms reporting unexpectedly high earnings relative to firms reporting unexpectedly low earnings. The size and book-to-market effects have been documented, among others, by Fama and French (1992). In particular, small market cap stocks have historically outperformed big market cap stocks, and high book-to-market (value) stocks have outperformed their low book-to-market (growth) counterparts. Sloan (1996) documents that high accruals stocks underperform low accruals stocks. Dichev (1998), Campbell, Hilscher, and Szilagyi (2008), and Avramov, Chordia, Jostova, and Philipov (2009a) demonstrate a negative credit risk return relation. Diether, Malloy, and Scherbina (2002) show that buying (selling) stocks with low (high) dispersion in analysts’ earnings forecasts yields statistically significant and economically large payoffs. Titman, Wei, and Xie (2004) document a negative relation between capital investments and returns, and Cooper, Gulen, and Schill (2008) document a negative relation between asset growth and returns. Finally, Ang, Hodrick, Xing, and Zhang (2006) demonstrate that stocks with high idiosyncratic volatility realize abnormally low returns. This paper examines the price momentum, earnings momentum, credit risk, dispersion, idiosyncratic volatility, asset growth, capital investments, accruals, and value anomalies in a unified framework. We explore commonalities across all anomalies and, in particular, assess potential implications of financial distress, as proxied by credit rating downgrades, for the profitability of anomaly-based trading strategies. It is quite apparent that a downgrade experienced by a low-rated firm, or even a concern of emerging financial distress, leads to sharp responses in stock and bond prices. Indeed, Hand, Holthausen, and Leftwich (1992) and Dichev and Piotroski (2001) show that bond and stock prices decline considerably up to one year following credit rating downgrades. The potential implications of financial distress for market anomalies have not yet been comprehensively explored. This paper attempts to fill this gap. Methodologically, our analysis is based on portfolio sorts and cross-sectional regres-