Earnings Season: Strike Now While the Iron is Hot

Includes: MEL, RAD
by: Chris Johnson

When you invest, it’s unreasonable to think that you’re going to gain ground steadily throughout the year. The market doesn’t, so why should you expect any different? The market usually trades within a range about 80 percent of the time and trends the other 20 percent. So how does that relate to your success?

If you can “tread water” during most of the year and then take advantage of opportunities during less frequent periods of more optimal market conditions, you’ll move your portfolio from average performance to much better than average. It’s similar to a baseball team that aims to win half their road games (tread water) and two-thirds of their home games (more optimal conditions). That translates into 95 wins per year, which will win a division most any year.So what are the “more optimal market conditions” that I refer to above?

Earnings. There’s a reason why seasoned traders look forward to earnings season every quarter. No market event offers more trading opportunities. Every company has to report them. And that means every report contains the seeds of opportunity. Will earnings exceed expectations? Disappoint? More importantly, how will the market react? Earnings create expectations. They create volatility. They create trading volume. And they do it like clockwork, for about a month, four times every year. If there’s one thing investors want to see in their investments, it’s movement. And there’s no better time to see movement in share prices than during earnings season.

OK, so how do you go about taking advantage of earnings season? Though opportunities are plentiful, it isn’t easy (no big surprise there). Consider all the factors that go into a company’s earnings results. Revenues and expenses can come from hundreds or thousands of sources. For the analysts that have a handle on these numbers, it’s still a crapshoot as to how these variables actually play out. Think about it, a few unexpected changes in these variables, and the final earnings number can get turned on its ear. Plain and simple, investing based on earnings expectations alone is a game of chance, at best.

Let me briefly tell you about my background. I started in the financial services industry as a broker with one of the largest firms in the country. This was back in the days of the squawk box (yes, before the CNBC show) that proclaimed the collective wisdom of the company’s New York analysts to the drones in the field. Armed with the hottest daily research from the “magic box,” we would call our clients about these buying opportunities. I didn’t know it at the time, but I was playing a game of chance. My mentor, Andy, sat me down one day and gave me a phrase that I use every day: “Luck prefers the prepared person.” He knew that the market was driven by factors beyond those published in the research reports and the daily squawk box transcripts.

From this, I learned that how the market behaves toward a stock ahead of earnings provides an enhanced view of what to expect after earnings.The answer lies in expectations. It’s not whether a company beats earnings estimates; it’s whether they beat the market’s expectations. If the market sets the expectation bar high, it becomes very hard for a company to impress the market and for the stock to climb. On the other hand, a stock with low expectations doesn’t need much of an inducement to get the buyers back in the game. That’s why knowing the true expectations of investors (as gauged by what people are actually doing with their money) is so important around earnings season. It’s not enough to just understand the fundamentals; you have to understand investor sentiment.

Last week I picked two stocks ahead of their earnings reports based on the behavioral environment that told me the Street’s expectations were less than optimistic. I look at a number of indicators that gauge expectations heading into earnings. I also look at the technicals and fundamentals, which have to show some strength if I’m considering a bullish play. An underloved stock with a solid chart sets up an ideal bullish situation, because expectations are low and sideline money should be available to boost the shares. So how did my picks do?

The first, Rite-Aid (NYSE:RAD), actually missed earnings by a penny. But the stock shot out of the gate after my buy recommendation, climbing as much as eight percent higher over the next three days. Why? The pessimism that had built up into earnings unwound into short-term buying, which propelled the shares higher. I’ll take eight percent in three days. Won’t you?

RAD 1-yr chart


The second stock - Mellon Financial Services (MEL) – gained ground after last week’s article but before earnings. I saw that expectations were low and felt the stock had a lot of upside that could be enhanced by an average earnings report. MEL jumped more than four percent in just three days, although it didn’t do much after earnings, which merely met estimates.

MEL 1-yr chart

The point is that I made a low-expectation play that was based on pre-earnings pessimism, which unwound into a solid short-term gain.It isn’t often that the market offers numerous solid trading opportunities. That’s why I love earnings season, and you should too. If you know what the market is thinking before earnings, you can make these opportunities even better. So strike now while earnings season is in full force.