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3 Reasons Why This Earnings Season Will Be Different

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March 31, 2012 - 3 Reasons Why This Earnings Season Will Be Different - By Zacks Investment Research

By: Jared Levy

Only four times a year do we get to take an in-depth, inside look at the health and well-being of major corporations. These four checkpoints can offer important signals on a stock's journey to glory or oblivion.

Ok, maybe that's a little dramatic...or is it?

Most of you already know that delivering strong earnings results are essential to the growth of a company's stock and, without consistency in those results, stock prices can be affected dramatically.

Take Netflix for example; here is a company that seemed destined for greatness and could almost do no wrong, but after some comments from their CEO and a couple negative earnings reports, the stock lost 75% of its value.

RIMM is another example of how some insight into a company's strategy (or lack thereof) and future expectations or products could have dramatic effects on the stock price. In early 2011, after RIMM's co-CEOs basically pulled a complete 180 on an earnings conference call, the stock went from $70 to $20 in a heartbeat.

Both are extreme examples, I know, but both are proof that a change in even the perception of earnings results can have dramatic effects on a stock's price.

There are a few key reasons why this earnings season will be unique and more volatile than others we have seen in the recent past. Let me share them with you below with insights on why some stocks will soar. And some will plummet.

Reason #1: Reversion to the Mean

The popular bullish argument for this rally is the fact that stocks are cheap on a price to earnings valuation basis. The S&P 500 total P/E is about 15 when you market weight the index (which is a fair valuation). When you equal-weight the index (give all the stocks the same percentage) the P/E is actually 17; a little on the high side for a sluggish economy. But when you look at some of the recent high flying stocks (which are prevalent), not only are their P/Es much higher, but their stock prices are also up 30%, 40%, 50% and more over the past 3 months.

For us statistical folks, this is abnormal considering not only historical market movements, but the VIX itself. The VIX tells us what the expected annualized volatility is. A VIX of 17% implies that the market should move (1 standard deviation) about 17% in a year's time or about 8.5% in a normal quarter...MUCH less than the big runs these stocks have made. It's like having a really warm day in Chicago in the dead of winter; you know it won't last long.

You don't have to understand the entire mathematical process; just know that statistical, technical and algorithmic traders are looking at these numbers and thinking it might be time for a pullback. While it likely won't happen to every stock, the unfortunate ones that miss their earnings estimates could get a serious wakeup call as this reversion to the mean phenomenon plays out.

Reason #2: Risk/Reward Coming Back Into Balance

Another key to this earnings season will be that professional traders and investors are no longer blindly throwing their money to US equities. There is a psychological shift occurring, putting an end to the "buy on good OR bad news mentality".

Take the durable goods number last week; it wasn't that bad, but the market moved lower. In contrast, we have seen the market actually react positively to weak consumer confidence, housing data and more over the past three months. I believe this not only because of the irrational exuberance that was driving investors to buy, but also because there was really no other place to put your money. CDs are horrible, Bonds are returning next to nothing, Europe looked like it was on the brink of disaster and China growth was contracting sharply.

Now that the world might be healing a bit, investors may have alternatives to the US equity market, which means that US stock investments will need a little more than just being on American soil to attract buyers.

Reason #3: How Efficient Can You Get?

Last Thursday, Best Buy announced earnings and posted a Q4 loss, partly due to restructuring charges. Even though Best Buy slightly beat Wall Street's expectations, the reality was that their top line (sales) growth was sluggish and that's where the pain began. They also fell short in their full year revenue guidance, which drove its stock down 6%.

Shares are almost back to where they were before the recent rallies.

Best Buy also plans to close 50 big box stores in the U.S. over the coming year and cut $800 million in costs by fiscal 2015. I'm not good with math, but I'd say that cost savings may equal more profitability, but closing these locations will mean more people out of work, which is not good for a country that needs jobs desperately.

The point of all this is that many companies are operating at or near peak efficiency, meaning they have cut costs as must they can. If their real sales (top lines) are not improving, than it will be hard for markets to justify the recent rally and continue higher.

The next step for a company that is operating at peak efficiency, but not making more money, is to perhaps cut employees, close or move locations or take other potentially drastic measures. Corporate strategy and outlook will get close attention this quarter. Last quarter, companies were generally ambiguous about their forecasts for the year. Now that we are four months in, investors will want to know what the landscape looks like. Without a clear, positive outlook, investors may again become cautious and sell their shares, sending prices lower.

Earnings Are Upon Us

The new earnings season unofficially kicks off when Alcoa reports results on April 10th. From what you've read, you might be able to tell that I am a bit cautious this season. The take home for you will be to pay close attention to the details of past reports of a company and what they thought about the coming quarter. Look at their lineup of products and/or services and how consumer trends are helping or hurting them.

This season will require a little more work on the part of the investor to target the best companies that are most likely to not only grow, but exceed expectations. There will be those companies that see their shares move lower even on a good report; but the selloffs shouldn't be dramatic.

Don't be greedy! If you have some profit on the table, don't be afraid to take some off ahead of the report and reduce your risk. If you are planning on holding through the report, it wouldn't hurt to have a system or checklist that you review before making that decision.

When to Get In and Out of Stocks

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Good Trading, Jared

Jared Levy is a Zacks Rank stock strategist with special expertise in earnings surprises. He provides private recommendations and commentary for the groundbreaking Zacks Whisper Trader.