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Earnings Season Impact



Earnings Season – Unique and More Volatile!



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earnings season

April 03, 2012

Introduction

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:

OR,

more importantly, to the investors and traders profit or loss!

The Importance of Strong Earnings Results

Most investors 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.

Here are a couple of examples in relation to this statement:-

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

Research In Motion Limited (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 degrees on an earnings season conference call, the stock went from $70 to $20 in a heartbeat.

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

Reasons for a Unique Earnings Season

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. Below is an insight into why some stocks will soar -- and some will plummet dramatically!

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 Price-Earnings Ratio (P/E Ratio) 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/E’s much higher, but their stock prices are also up 30%, 40%, 50% and more over the past 3 months.

For investors and traders who are statistically-minded, this is abnormal considering not only historical market movements, but the CBOE Market Volatility Index (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 block of ice in the middle of summer with no freezer; 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 season estimates could get a serious wake-up call as this reversion to the mean phenomenon plays out.

2. Risk/Reward Starting to Return to 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".

For Example: 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. It is a belief that this is not only because of the irrational exuberance that is driving investors to buy, but also because there has been no other profitable place to put their money. CDs are horrible -- Bonds are returning next to nothing -- Europe has been a disaster for far-too-long – and – China’s growth has been contracting sharply.

A 'Certificate Of Deposit - CD' is a savings certificate entitling the bearer to receive interest. A CD bears a maturity date, a specified fixed interest rate and can be issued in any denomination. CDs are generally issued by commercial banks and are insured by the FDIC. The term of a CD generally ranges from one month to five years.

CDs are low risk, low return investments, and are also known as "time deposits", because the account holder has agreed to keep the money in the account for a specified amount of time, anywhere from three months to six years. CDs offer higher rates of return than most comparable investments, in exchange for tying up invested money for the duration of the certificate's maturity. Money removed before maturity is subject to a penalty.

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.

3. Limits to a Company’s Efficiency!

It is important to realize, before investing in a particular stock, is that many companies are operating at or near peak efficiency, meaning they have cut costs as much as 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.

An example of this was observed last Thursday, when Best Buy Co., Inc. (NYSE: BBY) 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 problems began. They also fell short in their full year revenue guidance, which drove its stock down 6%.

Shares are now 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. The idea of 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 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 Seasons Begins Soon

The new earnings season unofficially kicks off when Alcoa Inc. (NYSE: AA) reports results on April 10th. It is obvious from the previous remarks that “caution” will become a byword this season. It will be extremely important for the trader/investor to pay close attention to the details of past reports of a company and what they thought about the coming quarter before investing. Look at their lineup of products and/or services and how consumer trends are helping or hurting them.

This earnings 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 sell-offs shouldn't be dramatic.

Conclusion

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. If you are not currently familiar with options trading it would be advisable to check-it-out, as this may be another method of covering your risks and also profiting during the earnings season!

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