Let's be clear: on a day to day basis, the equities market can be baffling. Now that we're in the midst of earnings season, it's important to understand the potential risks (and rewards) of the waves of intraday
volatility that have become commonplace in the past few months. It's all about psychology, and if you want to make some money in the short term and protect your principal in the long term you need to know how to Play the Game--or at least have a good working knowledge of the rules. I'm briefly going to talk about how individual stocks trade before and after quarterly earnings reports both relative to their peers and to the broader macro picture, with special focus on the price action of Citigroup (NYSE:C) during the week of 7/12-7/16 because it's a perfect illustration of what I want to get across.
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Earnings season is increasingly about relative perceptions. Sure, everyone knows a given company's earnings estimate, and conventional wisdom is that surprises either to the upside or the downside exert directly-proportional pressures on its share price. While this is still true to a degree--Intel (NASDAQ:INTC)'s blowout quarterly report early last week sent its shares soaring for a day or so--it's increasingly taken a backseat to the kind of 'buy the rumor, sell the news' outlook that has for the past few years or so driven the market in the absence of any clear fundamental guidance. This type of trading, which is most effective on a short-term basis thanks to hedge funds' rapid-fire robot trading programs and even shadier high frequency trading outfits' highly-efficient algorithms (there was a great New York Times article about the rise of high frequency trading out a few months ago), can and does create incredible spikes in volatility that spook even the savviest retail/long-term investors. And rightly so! The refrain for retail brokerages and 'good guy' value investing gurus this year has been 'turn off CNBC and stop watching your stocks minute-by-minute.' Value investing isn't dead, they say, you just have to understand that it's going to take a while to see returns from such a strategy--which is easier said than done in the me-me-me-now-now-now world we've come to live in. Well, that might be true in theory, but when enough retail investors--the guys and girls who just want to grow their savings and provide for their kids--are convinced that the stock market has become a casino, the implicit trust that governs the interplay of these supposedly rational economic actors will begin to break down.
A good first step you 'good guys' out there can take to lower your financial blood pressure a little is to understand, really fully understand and feel, that the talking heads you see on CNBC, just like the talking heads you see on FOXNEWS or MSNBC, are paid to exaggerate and sensationalize. It's all about what sells! On the market's up days, everyone talks about how great everything is going and how we're finally climbing ourselves out of this economic hole we dug; on down days, everything is coming apart again and we should all buy gold or treasury bonds or whatever else. That's the first thing. But ultimately it's less important than understanding that people who know more than you do--because they it in front of powerful computers and are paid to do this for a living, among other things--exploit this crazy back-and-forth uncertainty to their benefit.
Take the price action of Citi the week of 7/12. The stock outperformed the broader market, which itself was rising, by an impressive margin, rocketing up from the 3.80s the week before to close above 4.30 on Tuesday. The explanation for this is 'simple' if you don't mind a little doublethink with your Psychology 101: having seen good earnings from Alcoa (NYSE:AA) and Intel (INTC) a few days earlier, hedge fund managers and other institutional investors knew there would be a groundswell of optimism for the bank earnings period starting with JP Morgan (NYSE:JPM) after hours on Wednesday. Figuring they could grab some Citi at a relative bargain around 4 and quickly bid up the price--hence the quick whoosh up into the 4.20s by early Wednesday--exciting the 'good guys' who they figured would be recklessly enthusiastic enough to buy the stock even after a huge run-up in the expectation that the price would continue to increase through the Friday earnings report and possibly beyond with a big enough upside surprise. That's how it's supposed to work in the real world, right? You buy a stock before an earnings release if you think it's going to report better-than-expected income because that's how value is created. You're taking a chance, sure, but the premise is simple enough: you bet that earnings will surprise to the upside and that extra, added, unexpected (or whatever you want to call it) value will encourage other investors to continue buying into a now-more-attractive company. If earnings disappoint, well, you're out of luck, but if you're doing your homework right you should be able to call earnings reports fairly well.
But the logic of this trade broke down on Thursday morning in preordained fashion, blindsiding the good guys and filling the hearts of the hedge fund managers and HFTers with cold delight. Here's the thinking: once JPM had reported earnings, no matter how good they were going to be, there was nothing left to anticipate. As two major banks with similar loan portfolios which were both recovering from the same financial crisis, JPM and Citi were always going to have roughly equivalent quarters. And though JPM did a bit better than most folks in the know had expected, it ruined the anticipation for Citi's (and Bank of America's) earnings later on in the week. The game was up, everything was on the table, and the only thing left to do was sell before anyone else did--hence the precipitous two-day fall back down to pre-earnings-week levels. See, as far as the banks' financial health goes, it's going to be a long slog--things are improving, but not overnight, and it's going to be at least a couple years before we start seeing earnings anywhere near pre-crisis levels. That's not necessarily a bad thing. But the guys who control large sums of institutional money--guys who watch the market for a living, who use machines and complex algorithms to maximize their profits and minimize their losses every minute of every day--figured that by bidding up the price of (C) they could a) convince the good guys that there some value had magically appeared on Citi's books, that what's coming three to five years from now was all the sudden going to come last week, and b) make a quick buck selling after a 15% two-week run. This sort of action isn't unique to Citi shares by any means--take a look at the behavior of GE and others around their earnings reports.
If you think anyone was going to let the price of (C) get any higher than, say, 4.40 (it topped out at 4.35 after hours on Tuesday), you're not thinking the way you need to to protect yourself from these guys. That's what you need to do: think like a hedge fund manager, think like someone who makes a living psyching out the market, think like someone whose take-home depends on making the trade before anyone else. Good luck!
Chart source: Yahoo! Finance
Disclosure: Long Citigroup