A Strategy for Earnings Season Fears

Oct. 3.06 | About: iShares Russell (IWN)

Earnings season is a great spectator sport. But being in the game often hurts, as stocks get hammered when companies fail to fully meet Wall Street expectations, even if they do well in an objective sense. Frustrated investors may wish they had sold everything beforehand, watched CNBC for a month and resumed buying after all the numbers were in. A simple test involving the Russell 2000 Value Index Fund (NYSEARCA:IWN) exchange traded fund suggests such a strategy might, actually, be plausible.

Table A tracks the performance of the Russell 2000 ETF from August 2000 through September 2006 under two assumptions:

  • The all-months version is a simple buy-and-hold approach. It produced an overall price gain of 139.37 percent.
  • The spectator strategy assumes ownership of the ETF eight months out of every year but being all cash during each January, April, July and October, these being the heart of earnings season. During the cash periods, we assumed a return at a rate that would annualize to 2 percent. This approach produced an overall gain of 118.73 percent.
  • At first glance, it would seem preferable to stay in the game. After all, you need to play if you want opportunities to benefit from upside earnings-season surprises.

    A closer look at the numbers suggests otherwise.

    First, the margin of victory achieved by the all-months strategy is very narrow: 20.64 percentage points over a little more than six years. The spectator strategy gains an edge, but just barely, when looking at only the average monthly return and standard deviation.

    So in one sense, it can be argued that this is, essentially, a draw.

    Next, bear in mind that 2003 was a powerful year in which the Russell 2000 ETF gained 46.42 percent as the market roared back following its 2000-02 collapse. The January 2003 earnings season was tough — company disclosures still reflected late-2002 business conditions — with the ETF having fallen 2.49 percent that month. But the next three earnings seasons were very strong: The ETF jumped 9.28 percent, 5.21 percent and 8.31 percent in April, July and October respectively.

    Unfortunately for bulls, we don't often get years like 2003. When we do, it probably pays to take whatever earnings season looms, realizing we're likely to more than make up any downside with positive news elsewhere.

    Table B shows how the ETF strategies compared during a more normal, or at least less extreme, market environment. It shows the spectator strategy to be a more clear-cut winner.

    Moreover, during the post-2003 period, the spectator strategy seems strong enough to withstand higher trading costs.

    Assume an initial investment of $10,000. From January 2003 through September 2006, an investor using the spectator strategy would have had to trade the ETF 21 times. If we assume a discount-broker commission rate of $15.00 per trade, that would have added up to $315.00. After deducting these commissions as they accrue, the $10,000 initial investment would have been worth $15,194.54 at Sept. 29, 2006. The all-month buy-and hold strategy, which involves only one commission for the initial purchase, would have been worth $14,402.38. (Neither tally includes the distributions that are paid outside of earnings season and would, therefore, accrue under both strategies.)

    Note that this particular implementation of the spectator strategy is imperfect in the sense that some companies use fiscal years that require a different reporting cycle. Indeed, most retailers follow cycles that run a month later than is the case for calendar-year companies. An investor who fears retail stocks might, on balance, fall during earnings season could consider buying put options on a retail ETF during the months of February, May, August and November.

    In any case, whether one wishes to try to fine tune for retail or just accept the broad ETF as is, there does appear to be a demonstrable, investable, seasonal pattern relating to earnings season and the pain it often inflicts.

    At the time of publication, Marc H. Gerstein owned no shares of IWN but did own put options. He may be an owner of the shares, albeit indirectly, as an investor in another mutual fund or another Exchange Traded Fund.

    Note: This is independent investment and analysis from the Reuters.com investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by Reuters.com.

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