Trading strategies for earning abnormal returns may be developed by following signals of corporate distress or recovery. Using signals generated by two popular bankruptcy models—the Altman Z score model and the Wilcox X value model—the authors classified NYSE firms according to whether they were moving from health to distress or from distress to health.
For the 15-month period prior to the issuance of the annual report that triggered a shift in state, firms classified by the Altman model as recovering from distress displayed significant abnormal positive returns; those classified as deteriorating showed significant abnormal negative returns. Both groups continued to exhibit abnormal returns in the expected direction over the nine months following the announcement date. Using the Wilcox model as the discriminator of recovery, the authors found no abnormal return behavior before or after distress predictions but substantial anticipation of recovery signals.