Earnings Season Trading Strategy: Time To Catch Falling Knives

by: Eric Parnell, CFA

The heart of second quarter earnings season is about to get underway. Over the next three weeks, 385 of the 500 stocks in the S&P 500 (NYSEARCA:SPY) are set to announce their results for the just completed quarter. And those investors at the ready to buy in the immediate aftermath of some of the most eventful reports stand to capture what may end up being the best total returns opportunities remaining for the rest of 2012.

Many companies are facing increasing operating pressure as we move into the second half of the year. The economic outlook in the United States has been deteriorating for months, and the environment is even more discouraging outside of the U.S. Many leading Asian economies have also been slowing and circumstances in the troubled eurozone are as precarious as ever. Thus, companies are likely to face increasing challenges in generating revenue and earnings growth. And with corporate profit margins already historically high at more than +2 standard deviations above the long-term average, little room if any remains for companies to cut costs in order to avoid margin compression. In a normal environment, all of these forces would bode ill for the stock market outlook.

Of course, we are far from operating in a normal environment today, as the forces of monetary stimulus are now seemingly all that matters to the market. At first glance, a sharp correction for the major stock market averages would not come as a surprise in the coming weeks. After all, we experienced sharp cascading declines of -15% to -20% over the course of a few weeks both during the summer of 2010 and 2011. But while such an outcome certainly remains possible for the summer of 2012 and would absolutely make sense given the fundamental economic and market backdrop, it is far less likely this time around for one simple reason. During each of the past two summers, the U.S. Federal Reserve had just ended QE stimulus programs. As a result, the market was left to stand naked without the support of monetary stimulus, and it failed badly both times. This year, however, the Fed elected to extend its current Operation Twist stimulus program through the end of 2012. Although certainly not as potent as its QE predecessors in its ability to elevate stock prices, Operation Twist has shown the ability to provide stocks with just enough support to keep them from tumbling over a cliff. Instead, stocks appear likely to grind back and forth in a gradually declining trend over the next few months with explosive rallies along the way.

So if the fundamental economic backdrop remains poor, but monetary policy makers appear unwilling to allow the broader stock market to correct sharply, where exactly does opportunity reside in the stock market? The answer: at the individual stock level.

An outcome seen on any given trading day over recent months is the increasing investor unwillingness to tolerate any degree of unexpectedly bad operating news at the individual company level. The stock market could be trading +25 points higher on the S&P 500, but if a particular company revises guidance lower or misses on a quarterly report, it could find itself down -10% or more on the very same day. And such downside is not limited to riskier market fare, as some of the highest quality names in the market have endured these types of drubbings even in recent days. And it is with precisely these types of situations where investors may be best served to focus.

Several opportunities to fill the gaps with high quality names are likely to present themselves in the coming weeks. We have recently seen the following developing trend. A high quality company will release disappointing news on a given trading day. The stock price immediately gaps sharply lower as investors react to the company specific news. But once this sudden wave of selling is completed, the stock often finds a bottom and begins to gradually recover. This is due to the fact that the liquidity forces keeping the broader market stable start flowing in to fill the void.

Two recent examples illustrate what we might expect in the coming weeks if and when selected high quality companies disappoint with their latest quarterly earnings reports.

After the close on June 28, Nike (NYSE:NKE) released their latest quarterly earnings. Needless to say, the company fell short of expectations. And when the stock opened for trading the next day on June 29, it was down as much as -12.2% before ending the day down -9.4%. In the process, Nike stock decisively broke critical support at its 200-day moving average. But instead of falling further, the stock has bounced back impressively in the days since. Overall, it has gained over +7% in the subsequent nine trading days and now rests only -3% below pre-gap levels. Has anything fundamentally changed for Nike since being thrashed at the very end of June? Not really. But the stock price has certainly responded, which is notable.


Another example came from Procter & Gamble (NYSE:PG). On June 20, the stock gapped lower by -3% after cutting its revenue and earnings estimates due to decelerating growth from its developed markets. Now it should be noted that P&G shares were not deeply oversold following the immediate decline. As a result, they continued to grind lower for the next four trading days until they reached deeply oversold technical readings. But once this bottom was reached, the stock price quickly began moving to refill the gap. Over the next nine trading days, the stock rebounded by +4% and stood less than -1% below pre-gap levels. And in an unusual development, once activist trader Bill Ackerman stepped in by announcing a major position in the last few trading days, and P&G stock price took off to the races.

Such are the opportunities that investors may be well served to capture during the heart of earnings season over the next three weeks. Of course, any gap lower should represent a starting point, not an ending point, in making any investment decisions. The fundamentals associated with each position should still be examined closely for portfolio suitability. Developments in the broader economy must also be considered closely as they unfold. And in managing risk, a focus on high quality companies with low price volatility such as Microsoft (NASDAQ:MSFT), ExxonMobil (NYSE:XOM), IBM (NYSE:IBM), McDonald's (NYSE:MCD) and Hormel Foods (NYSE:HRL) remains a prudent strategy.

Given all of the challenges facing the economy as we move through the summer, the latest quarterly earnings season promises to deliver it share of suddenly falling knives. And standing poised to effectively catch the opportunities that present themselves along the way may prove rewarding in a stock market environment that otherwise remains highly uncertain.

Disclosure: I am long NKE, PG, MCD, HRL.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.