Every quarter, US companies are required to present a financial report to the SEC and subsequently the public, showing the financial performance of the company for a specific time period.
An earnings release date is scheduled for a specific date, with the company then issuing an earnings estimate for the upcoming time period (typically a quarter or year). This estimate is used by analysts, industry professionals, and the general public, to then evaluate an expected performance.
When the company releases their earnings data, they will meet, exceed or miss those expectations. This can cause the stock price to rise or fall quite dramatically. In fact, quite often we see stock prices gap excessive amounts when investors are shocked (positively or negatively) on the report.
Certain types of stocks (industry) have varying levels of volatility that influence investor reactions to earnings results. For example;
- Blue chip stocks or large conglomerates (Berkshire Hathaway; Johnson & Johnson; General Electric), are typically slower moving stocks (less volatile in price movement), and do not react excessively in stock price
- Biotechnology stocks (in the medicinal industry producing biological drugs), or even Technology stocks can react quite harshly when earnings results differ from expectations â€“ both good and bad.
During positive economic periods, also referred to as a Bull market, we normally experience positive reactions to earnings results. Even if the company reports as expected, or slightly misses, the share price might only react marginally and eventually resumes a broader growth trend.
Weak or negative economic environments will typically find companies missing their earnings reports. Or, revising their expectations down as revenue (sales) results decline.
As you can see, the broader economic environment can influence expectations and final results. So you need to be aware of where the broader economic/fundamental cycle is.
How do you manage/react to Earnings Reports?
Investors, those who purchase stock for long-term positions, typically need to ride through any stock market reaction. As a long-term investor, you are looking for capital growth and/or dividend returns. So as long as the earnings report, and the projected expectations continue to show growth potential, there should be no reason to adjust your position.
Traders on the other hand, are typically looking for short-term directional movements from stocks. Either up or down. But the uncertainty surrounding whether the company will meet, exceed or miss earnings expectations, means it is basically a wild punt as to how the markets will react to the report.
Sure, during steady economic environments there is more certainty. But I can quote many reports in the past where earnings have exceeded expectations but the stock price has still dropped. Apple comes to mind, several times over the last decade.
My recommendation to short-term stock traders is to not hold a position as it heads into its earnings reporting date. Make this part of your trading management plan, and avoid any high risk/uncertainty.
If you are really keen to try and trade those earnings fluctuations, the best methodology I use is with Options, trading what is referred to as the â€œVolatility Crushâ€.
The Voodoo that is October!
For the last 15 years, October has always been the earnings period where Iâ€™m sitting on a knifes edge.
My study and analysis of historic stock market crashes, and what I have experienced in 20 years as a professional analyst/trader, is that October is a common period for stock market crashes.
Performance economically/fundamentally through the middle of the year can lead to poor performance for companyâ€™s, who then reporting in October, result in missed expectations. Subsequently resulting in fear driven (panic) selling. The momentum shift leads investors to drive the markets down, and we get the â€œOctober effectâ€.
So, I am always cautious heading into the October earnings season.
2018 seems to have all the same warning signs that I have seen before. But just because I am concerned, does not mean I am running for the hills. Quite the opposite. I am cautiously evaluating as the weeks unfold.
Your management of positions through earnings season should be one that you are prepared for before the event. Your investment plan should include how you are going to manage your portfolio, including what parameters you need to see to maintain the position, what degree of change in earnings expectations from the company will define you exiting the position, and what your action plan is depending on the reaction of investors to the report.
Using the â€œHope and Prayâ€ method is not a strategy. You shouldnâ€™t leave anything up to chance.
While there is uncertainty in what a stock price will do in the future, you have control over your decision-making and what your course of actions should be. Being blindsided by the markets is really just an excuse for lack of analysis and insight. And even then, you should have an action plan prepared if something extraordinary occurs (as they do).
If you have any questions about earnings and stock price reactions, feel free to send me a message in the contact form below.