Profiting from Earnings Season Uncertainty

After rallying from the March lows, this week the “green shoots” camp will have an opportunity to put their money where their mouth is as we start Q2 earnings season. How can traders profit from the upcoming uncertainty?

Virtually all the financial press has stated that for the current rally to continue (or at the very least not to collapse) the “less bad” analysis is no longer good enough; starting this coming week, investors must see positive progress rather than the “less bad” optimism.

In short, this season earnings are not that significant but the forecasts for the rest of the year will determine the market’s direction. After a massive rally based on optimistic sentiment, it’s time to justify that sentiment-and-rally (if at all possible).

So how will “the market” try to spin earnings season?

Caveat Emptor

Put earnings in context by keeping the following points in mind. As the tsunami of reports start coming, companies who “beat estimates” MAY do so because of the following:

1. Artificially Low Analysts' Estimates. How many times have you heard of a company beating the “street’s estimates” by a penny? And that’s during normal times. Is passing an artificially low bar a sign indicating the end of the worst recession since WWII with historically unprecedented leverage by consumers and banks - are “green shoots” and a recovery right around the corner?
2. Accounting Games. I keep reading comments to my articles from “investors” that disapprove of trading, and these people are very belligerent about short-term trading. How about the GAAP accounting loopholes that allows companies to manipulate numbers to no end? Honestly, is chart-reading any less reliable that GAAP accounting? There are good traders and bad traders, just like there are good investors and bad investors. Not all buy-and-HOPE investors are the next Warren Buffett, no matter what they tell themselves. But hey, whatever helps you sleep at night. Bottom line: GAAP accounting is no more a legitimate crystal-ball of an uncertain future than chart-reading. That doesn’t mean chart-reading is bullet proof and the way to go. There are good traders and bad traders, just like there are good investors and bad investors; whatever works for you. I don’t talk down to investors, nor are my articles intended to “convert” them, so please show the same respect to fellow traders - and take GAAP with a grain of salt.
3. Temporary Government Stimulus. When looking at earnings, ask yourself what portion of the earnings was propped up from ridiculously unsustainable government debt and spending, and how long can this go on? Oh, by the way, the consumer is 2/3 of the US economy. How are they doing? Keep that (and the government spending) at the back of your mind when the reports come in.

Actionable advice for traders: Place earnings season in context as mentioned above, stay vigilant (this is not the time to open positions and walk away from the computer), realize what the market thinks matters (even if you think they’re wrong), don’t commit to big positions without the proper whipsaw protection (e.g., stops on your positions to get you out of a bad position, etc).

…And Learn to Dance

As I’ve mentioned in my previous article (DOW 6000, PART II):

… you should not think and trade as a “bull or bear”. Instead, you wake up every morning and decide where your dance-partner will lead you (long or short positions)…you trade the market you have, not the market you want.

The market sentiment going into earnings season is bullish, but as my previous articles have suggested, there is no change in fundamentals to support this bias. This doesn’t mean that the DOW is headed to zero; rather, keep that bullish-bias in mind (along with weak economic fundamentals) as we navigate the landmines ahead of us. Trade with the bias, but don’t get seduced by it (we’re not out of the economic woods yet, not by a long shot); the bias will change, and March lows will be retested.

The Big Picture

Monday

Economic Calendar: The Institute for Supply Management monthly service sector index. Analysts expect an improvement to 46 from 44 last month. For traders, the market’s reaction is more important than the numbers.

For a list of upcoming economic calendar events see here.

Wednesday

Economic Calendar: Crude Inventories, Consumer Credit

Earnings season starts with Alcoa (AA). Results from Alcoa may set the tone (bullish or bearish) for the market, and of course commodities traders. Stay vigilant and see if Alcoa’s report results in a bearish run on commodities; if so consider Commodities Short ETFs, among them: ProShares Ultra-Short Basic Materials (SMN), PowerShares Commodity Double Short ETN (DEE).

Thursday

Weekly jobless claims: While the number is important enough, when the report comes out, what you should be focused on is NOT JUST THE REPORT but the market's reaction to the report. What’s happening to the bullish-bias? Why is this important? Because the “bullish camp” is optimistic because of the “green shoots”; but in the end it's economics 101 - supply-and-demand - and the US consumer demand fuels 2/3 of the economy. People with no jobs don't purchase. There are limits to government spending…and yes, limits to even bullish-bias and optimism.

Conclusion

This is not a doomsday article. The DOW is not headed to zero, but as I mentioned in my previous article (DOW 6000, Part II):

…it’s not the end of the world, but we’re not out of the woods yet, the market loves to catch traders-&-investors wrong-footed.

Trade defensively and consider shorting via the Direxion 3x leverage bear ETFs (BGZ, TZA, FAZ).

Disclosure: No positions as of submitting article.

Comments

[Old Trader:]

"In short, this season earnings are not that significant but the forecasts for the rest of the year will determine the market’s direction."

I've noticed that an increasing number of companies have started to refrain from issuing forward guidance when announcing current earnings, which doesn't make life any easier regardless whether one is a "trader" or an "investor".

Jul 05 10:57 AM

[SlingWing9:]

UGL & AGQ are sitting on their upward trendlines, other commodities, i.e., DYY & DBC, have already broken down, SPY & DIA 15/30 mavg's have generated their first sell signal since the March low, major indexes all have MACD nonconfirmations - the list of technical sell signals is broadbased. I am in Serge's camp for my own reasons. I am "0" long. Principally a momentum trader, I'll be watching & looking to build positions in ERY, SRS, SKF, TMF, UGL, & AGQ. I love leveraged ETFs.

Jul 05 11:40 AM

[robert.b.fe...:]

I agree with Serge insofar as the "bullish bias" being unsupported by underlying fundamentals. That being said I am a buy to hold investor day trading gives me a headache and the thier whipsaw world can cause whiplash for the less than skilled. When the DIA breaks below 8000 I will resume bargain hunting as there will be some bargains out there. So for traders and investors alike build up your cash positions, maintain your watch list and do your due dilligence there is money to be made by all. And as Serge said it won't be the end of the world you just can't keep a good market down forever.

Jul 06 12:45 PM