Profit From Unreasonable Fear

by: Zacks Investment Research

By Jared Levy

The stock market never ceases to amaze me. You'll frequently hear things like "the market has a short memory" or "if we forget the past, we are doomed to repeat it;" but that's not the way things work at all.

In fact, the markets are extremely efficient at finding value for the facts that are known at that moment in time and risks are always factored in.

It's not that markets forget; they are simply looking forward, as we all should, towards the future. Think about where you'd be in life or how stagnant your evolution would be if you dwelled in the past all of the time.

The problem is that many retail investors forget the basis of what drives the market (earnings) and get caught up in the minutiae of the headlines, which are bound to confuse.

The market is comprised of people who read the news just like you and I. To look into the mind of the markets, you must go beyond the hype headlines, dig into analyst reports, earnings trends and, most importantly, pay attention to what the smart money is doing!

Instead of shutting down and fearing risk, we need to understand how to overcome and profit from the overblown risks I'm about to detail.

Just as Gordon Gekko said in the movie Wall Street, "One of the best tools you can have is information;" the real question is, "what information do you really need?"


The Risks Have Brought Down Expectations

Europe

Europe's woes are already factored in to an extent. I don't think anyone believes that everything is going to be hunky dory across the pond, and I know that many have even accounted for a Greek exit. What we will have are minor bumps on a long road to recovery. The powers-that-be will do what it takes to add stability.

China

China's growth is no doubt waning and, while some may question the quality of their economic data, most believe that they can sustain roughly 6-7% growth for the years to come, which is enough to keep things moving forward. Furthermore, many companies and commodities have already gone through substantial corrections in anticipation for their decline; Chinese markets are already close to 3 year lows.



Did I mention that a slowdown in China has dramatically reduced the prices for commodities like steel and cotton, as well as rare earth metals that are used to make things like the iPhone, batteries and other electronic devices?

To get the real story, I turn to commentary from companies like Yum! Brands (NYSE:YUM), who just reported a 23% jump in profits driven in large part by growth in China.

U.S.

A U.S. recession is another possible scenario that the market is pricing in (albeit with low probability). The good news is that recessions don't just "happen." They evolve slowly and their progression will materialize in economic data.

While the U.S. economy isn't growing by leaps and bounds, it is stable and most likely won't see any catastrophic downside surprises barring a natural disaster of some sort, so this risk is somewhat predictable and slow.

The biggest risk I see in the near future would be us going over the "fiscal cliff" because some believe it would occur quickly. While fears are valid on some levels, it would be extremely foolish for either political party to purposely doom the American people. Furthermore, the solutions are technically extremely easy. Even if January 1st comes and goes, there is still actually time to fix the problem. Even The Treasury Department has power to adjust the withholding tax; they could decide to keep last year's rates to prevent consumer stress from the tax increases. Washington could also lower tax rates retroactively at any time in 2013 when the Bush tax cuts end.

None of this has gone unnoticed. Goldman Sachs recently issued an analyst note addressing these issues. While they acknowledge the risks I outlined, they also expect the S&P 500 to reach 1575 (+10% from current levels) by the end of 2013.

Why Is All This Negativity Good?

Remember that all these risks are known and the market has figured them into prices already. It would take a major change in the current state of things to completely derail markets, which I don't think will be the case for the Q3 earnings season.

In fact, these risks might make things even better! The best market scenario is one where expectations are low and positive surprises abound. Think about it, would you rather have someone under-promise and over-deliver, or the opposite?

In Q2, expectations were for flat growth, but actual results showed a 4.4% increase in profits. It was an average quarter where roughly 65% of companies beat earnings expectations with only an average surprise of about 2.56%. These results were barely average and yet the S&P 500 gained 16%!

The one thing I didn't mention was the extremely low expectation for this earnings season. In fact, analysts are expecting Q3 earnings to come in 3% lower than last year. This effectively lowers the high jump bar from 7 feet to about 3 feet and may just make this one of the better earnings seasons we have seen.

Analysts hold the key to earnings success, and understanding their behavior can point us into the most probable trades. Don't be afraid to stay consistent, stay invested and keep your discipline.

It's often best to put money to work at a time when fear is elevated and expectations are extremely low, like now. Buying quality stocks ahead of earnings can be one of the most profitable strategies if done correctly.