Earnings Anomalies Can Produce Big Returns For Active Traders
Earnings are the bread and butter of the equities market. Earnings are how businesses are valued and the fundamental force driving every move the market makes. The only reason to own a stock is how much it earns because that relates directly to how much it is expected to earn, how much it might earn in the future, and how much you can earn by owning it.
With this in mind it only makes sense to think that understanding earnings, earnings expectations, and how expectations affect market prices is key to investment success. At the core of the earnings picture is the earnings power of an individual company. Individual companies either do or do not make money but that isn’t always what matters.
In many cases, it takes accounting experience and intimate knowledge of company business to really know what’s going on within a business but that’s what the analysts are for. They spend their days crunching numbers so we can go to our own jobs. Average investors like you and me have to rely on earnings statements, analysts, conference calls, and third-party research to get the details we need.
The Earnings Cycle And Stock Market Psychology
Earnings are released in quarterly reports required by the SEC. The amount of detail required will vary from investment vehicle to investment vehicle but in most cases, US stocks are required to give very detailed disclosure of their operations. You can use the SEC’s EDGAR system to peruse any report ever filed by a US company or use a website like SeekingAlpha where they aggregate press releases issued alongside their filings.
Stocks can be traded using strategies that target earnings because expectations leading up to and following the release are powerful movers of stock prices. Needless to say, when the earnings are good the stock’s price will move higher and when earnings are bad a stocks price will move lower.
Sometimes a company will give guidance on future earnings expectations. Guidance may be an outlook for growth to continue or a more specific figure for revenue or earnings. Guidance used to be commonplace but fewer and fewer companies offer it. This is because guidance sets a bar often hard to beat and, if the analysts disagree, can cause wicked sharp changes in share prices.
In between the earnings releases are the analysts, their reports, and outlook. The analysts will hash their numbers, rub their crystal balls, and produce a figure they think is close to what a business should earn in revenue and profits. Not all the analysts will agree, some will be high, some will be low, some will think the company is OK and others will rate it a sell.
The analyst’s estimates and, more importantly, the average of those estimates, will be compared to what the company expects and drive prices higher or lower in between the earnings releases. If the analysts think company guidance is too low the price of the stock may go up. If the analyst thinks the guidance is too high the price of a stock may go down.
When the earnings report is released the traders will look for two things. The first is how the company actually performed relative to how it was expected to perform. If the company reports better than expected that is good, the stocks price may rise if not that is bad and the stocks price may fall.
While the results of the current release are important, the trend of performance it more important. When it comes to investing there are three key questions to ask; are earnings positive, are earnings growing, and is earnings growth accelerating. If earnings for a company are positive, growing, and increasing the pace of growth on a year-over-year basis you can be assured the market will pay attention.
Why Outlook Is More Important Than Performance
While performance is crucial for a stock’s valuation it is the outlook that drives stock market psychology more often than not. Because stock values are based on the expectation of future earnings. When a stock is expected to earn more in the future it’s price will rise in expectation of that earnings boost. Likewise, a company that is expected to earn less in the future will see its price decline as the market discounts it to match the expectations.
The thing about expectations is this they are rarely met and when they are the reaction isn’t always what you expect. This is because of discounting, a word I mentioned a moment ago. Discounting is the mechanism by the which market receive information and then applies that information to the price of a stock.
When information comes in that stock is or isn’t expected to earn more next quarter than last, and this year versus last, that news is assimilated by the market and it affects the price of the stock in question. In that sense, you see that stock is valued on the forward earnings, not true earnings, and that is a cause for a lot of a stocks price movement.
Now, it may be a fiscal quarter, or year, before the expectations that drive a stocks price are realized. That is a lot of time for the market to change its mind. If the estimates and outlook continue to grow you can be sure that the stocks price will follow those expectations higher. If not the stock’s price is likely to remain flat or fall, depending on how the expectations for earnings change over time.
Eventually, it will be time for the company to release its earnings report and start the next cycle. If the report beats the expectations the stock’s price is likely to rise but if the report reveals that revenue and earnings growth is only as expected the stock’s price is likely to fall. It is likely to fall because an expectation of earnings growth was built into the stock’s price and that expectation has already been met. If the expectation has been met there is no reason for the stocks price to move which means no reason for speculators to own it.
More importantly, completing the cycle, it is always the outlook for next quarter and the next year that will drive the stock’s price in the now-period. A miss on revenue or earnings can be forgiven by an eager market if the outlook for better results is positive. If the outlook for growth turns sour the market could sell off hard. Merely having growth outlook fall short of expectation is often enough for 3%, 5%, and 10% stock declines.
Turnaround Stories Offer Good Stocks At Cheap Prices
A history of poor earnings, declining earnings, or steadily falling outlook can produce a downward trend in a stocks price. In this case, the same forces that drive stock prices higher when earnings are good will drive the price lower only faster. When a stock isn’t doing well prices tend to fall quickly which usually puts them at a discount relative to results.
The question at that time is once again what is forward outlook? If the company is not expected to bounce you shouldn’t expect the price to bounce back either. The caveat is once again with expectations and how they may not be met. If the next quarter’s results exceed expectations in their bad-ness you can expect to see the stocks price fall further because that weakness is not yet discounted by the market.
The opportunity for stock buyers is when a company’s earnings are expected to be unusually bad. This situation can push stock prices to extremely low levels, huge discounts for investors, that are often rewarded when earnings are not as bad as expected. If the turnaround continues and earnings are expected to improve further a new uptrend may be born.
How To Apply Earnings Outlook To Day Trading
The most efficient method of applying earnings and earnings-related stock market abnormalities to your trading is to follow the big picture. The big picture refers to the earnings power of the entire stock market. This is usually measured by a proxy, the most commonly referenced being earnings for the S&P 500.
The S&P 500 is the US broad market index and the best proxy for general business conditions. Earnings for the S&P 500 are a closely tracked figure and, in my humble opinion, the single most powerful driving force in the stock market.
When earnings are positive the stock market is happy, business is good, and dividends are flowing. When earnings are negative the stock market is sad, businesses are struggling and dividends are shrinking. These conditions are the basic forces of the market, they create bull and bear periods and set the overall tone of trading.
The problem that most traders have with earnings is outlook. Outlook is what earnings are expected to be like and the force that drives market direction from quarter to quarter. What traders need to focus on is the outlook for earnings growth. The assumption is that if earnings are stable, flat with no growth, the value of the stock market will remain flat.
If the outlook for growth is positive, as in earnings for the S&P 500 are expected to grow, then the market should move higher because it will be more valuable then than it is now. Just like with individual stocks, if earnings growth is positive and expected to accelerate over time you can expect to see the market to rally quite strongly.
The 2018 Market Is A Good Example Of Positive Outlook Gone Bad
Events in 2018 are a great example of how earnings expectations drive the market. Earnings growth in 2018 topped 25% in the 3rd quarter, the fourth and fastest quarter of double-digit earnings growth and yet the equities market entered a broad correction. Geopolitics can be blamed but the real cause is the earnings growth outlook.
The outlook for earnings growth began to improve in late 2016 and slowly built until reaching a crescendo in early 2018. At that time all the possible good news had been priced into the market and what happened is outlook began to dim. When outlook dimmed so did the perceived value of the market and that has led to correction despite outlook for positive growth in 2019. Because earnings growth acceleration is going to slow down for the next two quarters earnings cycles we can expect the market correction and churn to last that long too.
Use Earnings To Generate Trade Ideas
The trick is that, for the index to move higher, all the stocks within it must be moving higher too. That’s why it’s important to track earnings at least by the broad S&P sectors. There are eleven S&P 500 sectors and their data is readily available from sources like Factset Insight. With that knowledge, when the market is not moving in synch, you can target sectors or sub-sectors with particularly good or bad earnings outlook for potential trades based on strategy.
You can start by looking at broad industry news, analysts ratings/outlook, or TV news for ideas. Put together a short-list of interesting companies in good/bad earnings sectors and when they are expected to report earnings. At that point, a little technical analysis is needed to see what kind of trades look possible and from there a strategy for entry can be built based on outlook and expectation for earnings.