Stock Exchange: How Does Earnings Season Impact Your Trades?

The Stock Exchange is all about trading. Each week we do the following:

  • Discuss an important issue for traders;
  • highlight several technical trading methods, including current ideas;
  • feature advice from top traders and writers; and,
  • provide a few (minority) reactions from fundamental analysts.

We also have some fun. We welcome comments, links, and ideas to help us improve this resource for traders. If you have some ideas, please join in!

Review: What Motivates Traders to Trade?

Our previous Stock Exchange asked the question: What do Winning Traders Have in Common? The article acknowledged that to succeed in trading requires a variety characteristics, but one in particular stands out. We also shared a few reasons why many new traders often fail.

This Week: How Does Earnings Season Impact Your Trades?

There is a wide range of viewpoints on whether or not earnings seasons should impact your trades, and if so “how?” and “to what extent?” Here are few examples to consider.

Earnings Announcements Are Short-Term Noise: Some investors believe earnings announcements are simply short-term noise, and they have very little impact on the long-term value of an investment. Wall Street is too focused on quarterly numbers instead of long-term value, and investors would be wise to ignore the noise.

Earnings Volatility Creates Trading Opportunities: Some traders like the “short-term noise” created by earnings announcements, as mentioned above, because it creates trading opportunities. If the long-term thesis is still intact, but the short-term noise caused a sell-off, that is a great opportunity to trade (or perhaps simply to initiate a new long-term position). That’s how some market participants feel about Netflix (NFLX) and Facebook (FB) after their most recent post-earnings announcement sell-offs, as shown in the following chart.

Technical Trading Analysis: Taking the “trading opportunities” described above, on step further, can lead to the art and science of technical trading. Rather than simply acknowledging a general sell-off, traders can quantify the attractiveness of any opportunities created via technical analysis such as moving averages, volume changes, and short interest, to name a few.

Quantitative Earnings Momentum: Earnings momentum can encompass more that simply price and trading volume changes. For example, there is a myriad of traders who have quantified momentum in earnings (is earnings rising from quarter to quarter? by how much? Is there momentum versus analyst forecasts? Company guidance? etc.). Every quarterly earnings announcement provides a new data point for such analysis. For example, here is a look at some historical Facebook earnings data points to consider, especially after the most recently announced disappointment:

Earnings Volatility: When earnings is highly uncertain, volatility can increase, and that can create opportunities in the options market. For example, when volatility is high, so is the premium income that is available for selling options. Selling out-of-the-money put options (for the premium income) on stocks you would like to own (especially at a lower price) is an earnings season strategy that some investors and traders like to utilize.

Fundamental Earnings Momentum: According this recent Forbes article (Earnings And Stock Market Valuations), “it is apparent that barring some major unforeseen event, equity markets are likely to continue their ascent thanks to the recent explosive earnings growth.

The article goes on to say:

“Growth in earnings will translate into growth in equity valuations. We are currently experiencing historically strong earnings growth coupled with a strong pro-business political environment and the projected growth rates reflect this. It’s highly likely that the remarkable equity bull run still has some gas left in the tank.”

“Earnings and Sympathy” Trades: According to an article from Lightspeed (“How Earnings Season Provides A Great Opportunity For Sympathy Trading”) earnings season creates a lot of sympathy trades. For example, according to the article:

“There have been plenty of sympathy trades this earnings season alone. PepsiCo traded higher on its earnings beat on July 10, which is why Coca-Cola traded higher on the day. Shares of Domino’s Pizza trade down after it’s earnings report on July 19, which caused Papa John’s to trade lower.”

This is an interesting and well-known phenomenon, but it’d also be interesting if anyone can help clarify how to place these sympathy trades because almost instantaneously when Pepsi releases earnings, Coke’s price moves (i.e. the market seems pretty efficient in this regard). It’s an interesting idea, but not a strategy we use in our own trades.

Model Performance:

Per reader feedback, we’re continuing to share the performance of our own trading models, as shown in the following table:

We find that blending a trend-following / momentum model (Athena) with a mean reversion / dip-buying model (Holmes) provides two strategies, effective in their own right, that are not correlated with each other or with the overall market. By combining the two, we can get more diversity, lower risk, and a smoother string of returns.

For more information about our trading models (and their specific trading processes), click through at the bottom of this post for more information. Also, readers are invited to write to main at newarc dot com for our free, brief description of how we created the Stock Exchange models.

Expert Picks From The Models:

This week’s Stock Exchange is being edited by Blue Harbinger; (Blue Harbinger is a source for independent investment ideas).

Felix: I have some technical rankings (based on momentum) to share with the group this week. As you may recall, I look for uncrowded trades, and I typically hold for about 66-weeks, on average. This week I ran the Nasdaq 100 through my model, and the top 20 rankings are included in the list below.

Blue Harbinger: I see both Netflix (NFLX) and Facebook (FB) made your top 20 this week. We saw those two names both sell-off hard after earnings, but it looks like you’re still bullish over the next year at least.

Felix: That is correct. I am a momentum trader, and I am still bullish. Their momentum is still intact.

BH: Thank you for sharing that info Felix. And if I recall correctly you use stops and pay attention to macro factors for risk management purposes. I like these trades. Anyway, how about you, Oscar—anything to share with us this week?

Oscar: This week I ran our comprehensive and diverse ETF universe through my model, and the top 20 rankings are include below.

BH: Interesting list. I see you like Internet companies considering you ranked the online retail ETF (IBUY) and the Internet index (FDN) first and second. It seems like you agree with the earlier Forbes article that earnings has more room to run, and you’re playing this thesis with Internet stocks.

Oscar: As you know, I am a momentum trader. And as you may also know, my typically holding period is only about 6-weeks (I usually exit by rotating into a new sector or ETF). I am seeing very good momentum in these names right now.

Conclusion:

Earnings season brings uncertainly, volatility, new information and new opportunities. And no matter how you’re playing it (e.g. ignoring short-term news, trading volatility, or counting on more long-term earnings growth), the economy continues to be strong, and it’ll likely continue to bring earnings and stock prices higher. And further, the idiosyncrasies of many individual stocks continue to present tremendous opportunities to profit during this earnings seasons and beyond.

Background On The Stock Exchange:

Each week, Felix and Oscar host a poker game for some of their friends. Since they are all traders, they love to discuss their best current ideas before the game starts. They like to call this their “Stock Exchange.” (Check out Background on the Stock Exchange for more background). Their methods are excellent, as you know if you have been following the series. Since the time frames and risk profiles differ, so do the stock ideas. You get to be a fly on the wall from my report. I am usually the only human present and the only one using any fundamental analysis.

The result? Several expert ideas each week from traders, and a brief comment on the fundamentals from the human investor. The models are named to make it easy to remember their trading personalities.

Stock Exchange Character Guide:

Character Universe Style Average Holding Period Exit Method Risk Control
Felix NewArc Stocks Momentum 66 weeks Price target Macro and stops
Oscar “Empirical” Sectors Momentum Six weeks Rotation Stops
Athena NewArc Stocks Momentum 17 weeks Price target Stops
Holmes NewArc Stocks Dip-buying Mean reversion Six weeks Price target Macro and stops
RoadRunner NewArc Stocks Stocks at bottom of rising range Four weeks Time Time
Jeff Everything Value Long term Risk signals Recession risk, financial stress, Macro

Getting Updates:

Readers are welcome to suggest individual stocks and/or ETFs to be added to our model lists. We keep a running list of all securities our readers recommend, and we share the results within this weekly “Stock Exchange” series when feasible. Send your ideas to “etf at newarc dot com.” Also, we will share additional information about the models, including test data, with those interested in investing. Suggestions and comments about this weekly “Stock Exchange” report are welcome.

Trade Alongside Jeff Miller: Learn More.

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