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Next week the earnings season begins in earnest with both JPMorgan (NYSE:JPM) and Wells Fargo (NYSE:WFC) announcing before the open on Friday, July 12th. They are two large banks, both sporting healthy dividends (2.8% and 2.9%), and a low forward P/E (9.1 and 10.94) with slow but steady growth in revenues and earnings.

Over the last several months, I have been testing the proposition that the level of expectations prior to an earnings announcement is a better indicator of what the stock price will do than the actual earnings themselves. I call it the Expectation Model. Basically, I examine recent stock price activity, estimates vs. whisper numbers, past post-earnings price changes vs. results, current RSI levels, and come up with a measure of whether expectations are unusually high or low.

If expectations are usually high, there is an excellent chance that the stock will be flat or fall after the announcement, regardless of how much the company might surpass estimates, and conversely, the stock is more likely to move higher when expectations are low, even if estimates are merely met. (Unusually low expectations are generally less predictive of higher post-announcement prices, however - unusually high expectations more reliably predict lower prices after the announcement).

I have had some serious success with this model, including 12 out of 14 winning option trades. In the two losing trades, Lululemon (NASDAQ:LULU) and Accenture (NYSE:ACN), the model correctly predicted the direction of the stock price change after earnings (in both cases, down), but the magnitude of the drop was far greater than I had expected, and the option trades I suggested did poorly. While both companies bested estimates, the CEO of LULU resigned, causing the stock to tumble nearly 20%, and ACN reduced guidance significantly and the stock fell almost 15%.

Anyone who had paid attention to the direction my model predicted and instead of trading options had sold the stock short or sold it short and written short-term puts against the short stock would have had a nice gain for both announcement plays.

Let's check out how JPM has done after announcements, with the price changes from the day before the announcement until the Friday close after the announcement (some of the time, the announcement came before the open on that Friday, as it will this week).


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JPM has an astounding record compared to estimates, bettering them by an average of 26.8% over the past four quarters. While this record is exceptional, the interesting thing to me is how the market has reacted to each announcement -- mostly with a yawn. The only exception was in July 2012 when the company exceeded by a whopping 59% and the stock moved $2.03 higher (6%) - this was an unusual quarter because estimates were dramatically reduced due to the London whale disclosure. For the last three quarters, the stock has fluctuated by less than $.30 on the day following the announcement in spite of the company exceeding estimates by 17% each quarter. Investors seem to expect the company will exceed estimates and don't rush in to buy shares when they do.

Check out the chart for the last year:


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The stock has moved about 20% higher since the last announcement although it has backed off a little from its high ($55.90). With whisper numbers 9% above estimates and the steadily climb of the stock, it looks like expectations are on the high side. This means that any shortcoming on announcement day (earnings, revenues, guidance, margins, or anything unexpected) might result in a big drop in the stock.

If I were interested in buying JPM, I would wait until after the announcement because the price might well be lower. If I were an option trader, I would wait until Thursday and sell a diagonal call spread (buying Jul-13 55 calls and selling Jul2-13 54 calls) at a credit so that if the stock trades any lower than its present $54.70, a gain would be made. At the present time, that trade could be made for a credit of $.35. If the stock ends up below $54 (which I believe is most likely), the spread would gain the entire $.35 plus any residual value of the Jul-13 55 call. The maximum loss would probably be about $.50 per spread if the stock trades significantly higher.

The pattern surrounding WFC announcements is remarkably similar to JPM. Here are the results:


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The company has managed to beat estimates every quarter, albeit by a much smaller percentage than JPM, and the stock has not reacted well at all. For the last three quarters, the stock has fallen after the announcement in spite of beating estimates every time.

This time around, expectations seem to be great. Whisper numbers are higher than estimates, but not by a huge amount. However, the stock has enjoyed a dramatic run-up going into the announcement:


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The stock has moved almost 20% higher since the last earnings announcement three months ago and hit a new high on Monday ($42.97). Expectations appear to be exceedingly high. Any disappointment is likely to result in a big drop in the stock. If I were interested in buying WFC I would wait until after the announcement to make the purchase. If I were an options guy (which I am), I would buy Jul-13 43 calls and sell Jul2-13 42.5 calls for a credit of about $.15 while the stock is trading around $42.83 where it closed Monday. No matter how low it falls, there will be a gain of the credit plus the residual value of the Jul-13 43 calls. The maximum possible loss would be about $.25 per spread plus commissions.

Expectations seem to be quite high for both banks, and there is a good chance the stock might climb more in the three days leading up to Friday's pre-open announcement, but once that announcement is made, I expect the stock for both companies to trade lower than it closed on Thursday.

Source: How To Play The JPMorgan And Wells Fargo Earnings Announcements This Week