In the stock market, fundamentals are, for want of a better word, fundamental, but in the short term they are often overpowered by sentiment. Sometimes that works in a stock’s favor.
Tesla (TSLA), for example, announced earnings last week that showed a bigger loss than expected, bringing back the issue of another round of borrowing or even raising capital by issuing more stock. The immediate reaction in the stock was what you would expect after that, a big drop. But, one week later, all of that was forgotten and the overwhelmingly positive sentiment that surrounds that stock led to TSLA closing yesterday above its pre-earnings level.
Sometimes, though, market sentiment produces the opposite effect.
IBM (IBM) announced Q1 earnings on April 17, and it was good news in terms of the two major metrics. Both revenue and earnings beat expectations, but more significantly, after a long period of declines, revenue increased for the second consecutive quarter. That could well be a sign that the long-awaited turnaround at Big Blue is finally coming, and as such is hard to see as anything but a positive.
Still, when the good news was released, the stock fell out of bed:
Following that reaction, people started to look for reasons. The most credible was that forward guidance was disappointing, but the reaffirmation of an expectation for 2018 earnings of $13.80 versus expectations for $13.83 was hardly a disaster. It certainly doesn’t justify an immediate eight percent drop.
That drop is also hard to justify in terms of the blend of earnings. Revenue from IBM’s new mainframe computer, z14, was a bit disappointing, but twenty percent growth in cloud-related revenue is a good sign. Overall, while not a blowout earnings report, Q1 was solid for IBM, yet in the aura of negativity that surrounds the stock, that was regarded as a failure.
As you can see from the chart, that negativity has continued, bringing IBM close to the 52-week low, and that proximity to a natural support level sets up exactly the kind of trade I like.
The basic idea is simple enough, but with a twist. I would look to buy at current levels, say at 142, with a stop loss just below that 139.13 low, around 137. That would limit potential losses to less than four percent, with the twist coming in terms of the target and what to do should we get there. If we do bounce off the low, it is reasonable to expect a move back up to fill the gap that followed earnings, giving a target of around 153.
If we hit that initial target, however, it would be a sign that sentiment is beginning to shift, and that the market is looking at the fundamental value of a stock with a forward P/E of around 10. To benefit if that happens, I would look to sell only half of my position at that level, setting a stop-loss for the remaining position close to 150. That would lock in a good profit and establish a longer-term long position with a lot of potential upside.
There is a lot of supposition in the above explanation, but that is in the nature of trading, and can be indulged in if you can set up a trade with a limited downside such as that outlined. There is a chance that the negativity stays, or that over the next few months IBM justifies it with further disappointment, but with the tide seemingly beginning to turn and with the lows to give technical support that looks to be a risk worth taking.