- Leapday Quantitative Research Team
Downside market protection with earnings sentiment
Leapday’s REACTION signals predict short-term moves in individual stocks after earnings announcements. In this report we aggregate REACTION signals to create a daily sentiment score for all earnings activity on a given day and investigate whether this score is predictive of down moves in the stock market (SPY) on the next trading day. Between 2017 and 2022 H1, this sentiment score produced 303 indicators predicting down days in SPY out of 1,383 total trading days. The average return of SPY on days with an indicator was -0.08% as compared to an overall average return of 0.05% for all trading days indicating the sentiment score is predictive of down moves in the market. We then use this indicator as an overlay to a buy and hold SPY position to provide downside protection and enhance return. We find that the indicator can be used to boost annualized returns of SPY between 2017-2022 H1 from 11.8% to 17.3%, decrease maximum drawdown from -33.7% to -23.4%, and increase Sharpe ratio from 0.67 to 1.03. The indicator has been particularly strong in 2022 H1 boosting returns of SPY from -20.0% to +1.1%.
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Avoiding large losers is a sure means to outperform the stock market for a buy and hold strategy and often boosts performance more than overweighting large winners. This paper uses the Leapday REACTION signals, which predict short-term moves in individual stocks after earnings announcements, to investigate whether these signals can be aggregated to predict down days in the stock market.
Given the significant amount of investor attention to earnings events, the thesis this paper examines is whether negative earnings events affect overall market sentiment on days with lots of earnings activity (i.e., peak earnings season) and/or on days when the largest companies report earnings and if aggregate daily earnings activity can thereby predict down moves in the stock market as measured by SPY.
We proceed by creating an indicator to predict down moves in SPY using Leapday’s REACTION signals, producing summary statistics for the performance of this indicator, using the indicator as an overlay on a buy and hold SPY position to provide downside protection and enhance returns, and discussing the findings.
Creating The Downside Earnings Sentiment Indicator
The Leapday REACTION signals predict short-term moves for individual stocks after earnings events. They are delivered as scores ranging from -100 to +100 indicating the direction and strength of the signals. The signals are available at 2 entry points on the first day the market is open subsequent to a company’s earnings announcement: (1) 60 minutes after the open (t0 open + 60 min); (2) 10 minutes before the close (t0 close).
This paper examines if the REACTION scores for individual companies can be aggregated to predict down moves in SPY. Our focus will be aggregating the signals from the first day of trading after an announcement (t0) to predict moves in SPY for the next trading day (between the t0 close and t1 close). To create our “Downside Earnings Sentiment Indicator”, we take the following steps:
We use both the t0 open + 60 min and the t0 close signals. Our research shows that there is low overlap in the strongest signals between these two entry points. Since both entry points make predictions that cover the desired period of this study (between the t0 close and t1 close), we will use both to create the Downside Earnings Sentiment Indicator.
We filter REACTION signals for scores which represent approximately the top one-third of signals. We do this because our studies have shown that approximately the top one-third of REACTION signals have the highest predictive power.
For each of the 2 REACTION entry points (t0 open + 60 min and t0 close), we multiply an individual company’s REACTION score by that company’s trailing 20-day average traded value and create a daily sum for all companies that report earnings on that day (“Earnings Sentiment”). By multiplying the trailing average traded value by the signal, we give greater weight to larger companies, which have more influence on the market’s performance. To prevent extremely large and active companies from dominating that day’s Earnings Sentiment, we cap trailing 20 day average traded value at $250M.
For each of the 2 REACTION entry points, we calculate a percentile rank for the Earnings Sentiment based on the trailing year. We then take an average of these 2 percentile ranks (“Earnings Sentiment Percentile”).
We finally create our Downside Earnings Sentiment Indicator by using the bottom one-quarter of the Earnings Sentiment Percentile as a trigger. These days should be the weakest in terms of market sentiment because they have the highest weighting of REACTION signals.
Next, we examine the performance of SPY on days with a Downside Earnings Sentiment Indicator. Because the REACTION signals have out-of-sample history since January 2016 and the Downside Earnings Sentiment Indicator uses a 1-year rolling period to rank the Earnings Sentiment, the indicator’s history begins in January 2017.
We begin by examining the average return of SPY on days when there is a Downside Earnings Sentiment Indicator and compare that to the overall average daily return of SPY.
As Table 1 indicates, the average return of SPY is significantly less on days in which there is Downside Earnings Sentiment Indicator versus the average day indicating that the indicator has ability to predict downside moves and can potentially be used as an overlay on SPY to provide downside protection and enhance returns.
To better examine the robustness of this indicator, we next look at average returns of SPY on days when there is a Downside Earnings Sentiment Indicator by year and compare this to the average daily SPY return by year.
Except for 2017 and 2021, the Downside Earnings Sentiment Indicator has occurred on days in which the SPY had weaker performance than the average day of that year. This has been particularly true in 2022H1 indicating a strong downside indicator in recent market conditions.
Finally, since the early days of COVID (February - April 2020) had such extreme moves in SPY, we will remove those days from the study to make sure they aren’t skewing the averages. Table 3 below shows this.
Even with COVID removed, the days with a Downside Earnings Sentiment Indicator are weaker than the average SPY day indicating that the indicator is robust and can potentially be used as an overlay on SPY to provide downside protection and enhance returns.
Creating An Overlay On SPY To Provide Downside Protection
Below we use the Downside Earnings Sentiment Indicator as an overlay on a long SPY portfolio to provide downside protection. Our implementation of the indicator is simple. As the Downside Earnings Sentiment Indicator is available before the market close (using the aggregate of REACTION signals from t0 open + 60min and t0 close), we will exit a long SPY position at the close on any day with an indicator and re-enter a long SPY position at the close on the following day without an indicator. In other words, portfolio performance will be 0.0% on days with an indicator.
Below we show the performance since 2017 of a long SPY portfolio that exits the long position on the 303 days in which there is a Downside Earnings Sentiment Indicator. We compare this portfolio to SPY performance over the same period.
Tables 4 and 5 provide metrics associated with the chart above.
Table 4 above shows the Downside Earnings Sentiment Indicator works well as an overlay that provides downside protection on a long SPY portfolio. Annualized returns since 2017 are significantly boosted and returns are particularly improved in higher volatility years with large downswings including 2018, 2020, and 2022. Table 5 additionally shows that a portfolio using the Downside Earnings Sentiment Indicator as an overlay has significantly lower drawdown and stronger risk-adjusted metrics.
Next, we take a deeper dive into the indicator performance by examining additional metrics including hit rate and average winner divided by average loser. We study all days in which there is a Downside Earnings Sentiment Indicator and consider a winning day one in which the SPY was down and thus the indicator worked as intended and consider a losing day as one in which the SPY was up.
With a hit rate of 42.9% and a Avg. W / Avg. L of 1.62, these results indicate that the indicator boosts portfolio performance not because it is more often right than wrong but because it helps in protecting against large losing days.
Finally, we note that the indicator has been very helpful in 2022. While the SPY was down -20.0% in 2022 H1, a long SPY portfolio using the Downside Earnings Sentiment Indicator as an overlay was up +1.1% in 2022H1.
We have shown that by aggregating company-specific REACTION scores into a daily sentiment score, we can create an indicator that predicts large down moves in SPY. This indicator can be used by investors to obtain downside protection and significantly enhance returns by using the indicator as an overlay for a long equity portfolio. We believe these results exist because a large number of negative REACTION signals and/or the largest companies having negative REACTION signals affects market sentiment and is a destabilizing factor driving big downward moves.
The indicator has been particularly helpful in providing downside protection in 2022. With quantitative easing and cheap money replaced by inflation and rising interest rates, earnings announcements have become an increasingly important event providing a glimpse into growingly uncertain outlooks for companies. Thus, it is not surprising that a market sentiment score created from aggregating a given day’s earnings events has become a stronger indicator of the next day’s SPY performance.
Investors can use a Downside Earnings Sentiment Indicator in a variety of ways. Most obviously, they can use the indicator as an overlay to reduce drawdown and enhance returns in a long equity portfolio. A sophisticated investor will likely implement an options strategy in lieu of the methodologies described above. In addition, more active investors can use the indicator as a risk management tool in existing long equity strategies.
In this report, we present an approach to using Leapday’s REACTION signals as an overlay on SPY to provide downside protection and enhance returns. This overlay is based on aggregating Leapday’s company-specific REACTION scores on a given day to create an indicator that predicts down moves in the stock market (SPY) on the next trading day. Between 2017 and 2022 H1, this sentiment score produced 303 downside indicators predicting down days in SPY. When we use this indicator as an overlay to SPY by exiting a long SPY position on days with a down indicator, we find that the indicator boosts annualized returns of SPY between 2017 - 2022H1 from 11.8% to 17.3%, decreases maximum drawdown from -33.7% to -23.4%, and increases Sharpe ratio from 0.67 to 1.03. This overlay can be used to reduce drawdown and enhance returns in any long equity portfolio.
This material is solely for informational purposes and is not an offer or solicitation for the purchase or sale of any security, nor is it to be construed as legal or tax advice. References to securities and strategies are for illustrative purposes only and do not constitute buy or sell recommendations. The information in this report should not be used as the basis for any investment decisions. We make no representation or warranty as to the accuracy or completeness of the information contained in this report, including third-party data sources. The views expressed are as of the publication date and subject to change at any time. Hypothetical performance has many significant limitations and no representation is being made that such performance is achievable in the future. Past performance is no guarantee of future performance.