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
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.
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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
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
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
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
When to Get In and Out of Stocks
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