This may be one of the most important earnings seasons in a long time. That is because investors are worried about how the ongoing trade war with China and rising interest rates will impact stocks. Recently, the major market averages have all bumped above their 50-day moving averages, but many have failed to get above the longer term 200-day. So, if corporate earnings are better than expected, then it should act as a catalyst propelling stocks back to the highs. On the other hand, if profits fall short, then stocks are likely to experience a nasty correction back to the recent Christmas Eve lows.
That is the story for the overall market. As for individual stocks, there will be big winners and losers depending on the strength of their reports. This brings to mind one of the most confusing things about earnings season;
Why do some stocks skyrocket on a positive earnings surprise while others fall off a cliff?
In this article we are going to tackle this little understood issue. Better yet, I will share with you two ways to profit from surprises this earnings season. More on that later.
3 Reasons Stocks Can Drop After a Positive Earnings Surprise
1) Estimates vs. Expectations: The standard definition of an earnings surprise is when actual earnings comes in higher than earnings estimates. But those estimates are the “published” numbers from the brokerage analysts. Quite often investors tend to develop their own unique set of expectations that can differ greatly from the Wall Street analysts. If there is too much optimism ahead of the release, then actual earnings will need to be a blowout in order to appease investors inflated expectations. This is the most common reason why some stocks fall after a “supposed” earnings beat.
2) Quality of Earnings: The highest quality earnings come from having robust revenue growth. This means that the company’s products or services are in high demand and should stay that way into the future. However, these days far too much of the earnings being reported is generated from cost cutting and other “accounting gimmickry”. The problem with that is that the benefits of these moves don’t last. When the market gets a whiff that the earnings are unsustainable, no matter how strong the beat, shares will most likely drop.
More . . .
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3) Forward Guidance: Plain and simple, when you buy a stock you are taking an ownership stake. And what owners of companies care about is the stream of future earnings. So if a company beats earnings for the quarter just reported, but warns that future quarters will see lower earnings, then that stock will go down…and go down fast.
2 Ways to Make Money on Earnings Surprises
So now that we have outlined things that can go wrong after an earnings surprise, let's shift gears and talk about something even more important; How to turn a profit from earnings surprises. Here are two ways to go about it.
Good Way: Buy shares in any company that had an earnings surprise and rose the day following the news. These stocks experience what academics call the "Post Earnings Announcement Drift”. Studies clearly show that these stocks usually outperform the market over the next 9 months. Conversely, you should sell any stock in your portfolio that misses its earnings numbers as it likely to underperform the market for the next few quarters. The downside of this approach is that there are literally thousands of stocks to choose from every quarter.
Best Way: Find stocks where the earnings “whispers” tip you off that a big surprise is coming. Buy the shares shortly before the announcement and enjoy quick gains of 10%, 15%, 20% when the earnings surprise is officially reported.
I know what you’re thinking. There are no Magic 8-balls for the stock market, so how can this possible??? But fret not; this isn’t a magic show. It’s pure science.
The concept of finding a profitable source of earnings whispers has long been the Holy Grail of stock investing. Many experts have tried and failed to make this work. In fact, we had been researching this for countless years.
Early on we found clues that told us which stocks are more likely to surprise, but not necessarily rise in price. It wasn’t until the summer of 2010 that we discovered the right combination of elements. Since refinements were made in 2014, the system has correctly called POSITIVE surprises a whopping 80% of the time with the vast majority accelerating in price.
Where to Find These Stocks
I can't share all the details of the secret formula with you, but our system relies on two under-utilized signals coming from the brokerage analyst community. These two whispers are then layered on top of other time-tested elements such as the Zacks Rank and Zacks Industry Rank to find only the best stocks... in the best industries... with the best chances of beating earnings and quickly rising in price.
If you would like to receive our precise whisper trading signals through the heart of this earnings season, I invite you to check out our Zacks Surprise Trader.
This is the time to do it. Right now, "Positive Surprise" signals are flashing for 3 companies that are reporting earnings this coming week. Here's the timeline:
• Deadline to get into the portfolio is midnight Sunday, January 27.
• One new surprise stock was just posted and 2 more will be revealed Monday morning.
• These companies report earnings starting after market close Monday.
Don't miss your chance to beat Wall Street to the punch and make the most of the potential double-digit price pops. Our signals predict big positive surprises and they've been right 80% of the time. In fact, our Surprise Trader portfolio recently closed gains of +40.7%, +16.7%, +29.6%, +28.1%, and +13.6% in as little as 4 days.1
Another reason to look into this right away is that you are also invited to download our just-released "Early Warning Alert" report. It reveals Stocks to Sell BEFORE They Report Earnings in the Coming Week. Our strategy works both ways, and you can use this report to avoid companies that are more likely to report negative surprises from January 28 – February 1.
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Wishing you great financial success,
David Bartosiak is Zacks' resident earnings surprise expert. He selects stocks and delivers daily commentary for our Surprise Trader portfolio.
¹ The results for the companies listed above are not (or may not be) representative of the performance of all selections made by Zacks Investment Research's newsletter editors.