The Changed World of Earnings Season
When I first started at Cabot back in 1999 (can’t believe it’s been more than 20 years …), earnings reports were important, but not an event we paid that much attention to, and earnings gaps were largely nonexistent.
Sure, we might listen to the conference call and look at the quarter’s sales and earnings, along with any forecasts of the future. But, even though we invested in incredibly volatile stocks (this was the Internet bubble, remember), the reports rarely resulted in a dramatic move in the stock-maybe up or down 2% or 3%, but nothing overly large.
Then came Regulation FD, which pretty much eliminated the wink-wink-nudge-nudge relationship between analysts and top management when talking about how a quarter was going. By eliminating the flow of insider information, that law made earnings reports hectic, make-or-break events for many growth stocks.
However, with volatility comes opportunity, and given the dramatic moves many stocks now make following earnings, it turns out you can use earnings season to your advantage … but not in the way most investors think.
For many investors, the goal is to find out which stocks are going to gap up 5%, 10%, 15% or even more after their earnings reports, while avoiding (or shorting) those that gap down.
Makes sense, right?
But it’s pretty much impossible, trust me, I’ve looked at various measures (big-caps vs. small-caps, how the stock was acting ahead of the report, etc.) and all I can say is that any one stock’s exact reaction is pretty much a crapshoot.
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If you think about it, it makes sense. Say a stock is at 50 before it reports, and then the next day, it gaps up to 55, a 10% jump. Well, that jump is because so few investors anticipated such a good earnings result (or positive forecast, or whatever the case may be).
In the old days, when analysts rubbed elbows more often with CEOs, the stock might have been selling at 53 ahead of earnings because the good news was known among the smart money, and the post-earnings jump to 55 wouldn’t be so surprising.
Hence my answer to every investor’s question about whether they should buy XYZ stock right ahead of earnings: Doing so is more gambling than investing, so if you want to do it, keep your position small (no more than half your normal size, dollar-wise).
I’m more inclined to let others try to game the earnings reaction and let the reaction guide me toward new leaders.
How to Play Earnings Gaps
How so? Well, I’ve often written that a big gap up following earnings report is very bullish, especially for the intermediate-term. It represents a big change in perception that usually leads to further buying or selling in the weeks ahead.
Yes, yes, I know it’s hard to go out and buy a stock that just gapped up a bunch, but that’s why it works; only after a few weeks of the stock doing well do most investors usually say, “hey, this looks like a real winner.” That’s why you need to follow the evidence and not your gut!
But is it as simple as looking for a stock that rallies, say, 10% or more on earnings and buying it? Of course not. But stocks with the best chances of gapping up and running from there share some common characteristics. (Note: A gap is the most bullish, but what really counts is the stock’s overall move in reaction to earnings. If it doesn’t gap up but still advances 15% on the day, that’s nearly as bullish.)
First: The earnings move should be big. There’s no set amount, but I use 10% as a rough threshold. If a stock pokes up 4% or 5%, hey, that’s great, but it’s not the kind of get-in-now power that you’re looking for in this instance.
Second: Never, ever, ever underestimate a big earnings move up in a big, liquid stock … even if the stock doesn’t seem to have a major growth story. I’m not saying you should plow into IBM if it gaps up 10%, but then again, to get a stock that big to move that much probably means something BIG and bullish is going on.
Third: Check the volume. We’ve found that decisive earnings gaps higher that come on quadruple (or more) average volume tend to work better. With huge, liquid stocks-say, stocks that trade over $200 million per day-triple average volume can do the trick. And if you’re looking at thinner stocks, you might demand something like five or six times average volume. But in general, quadruple volume is something to look for.
Fourth: Look at the stock price range, and where the stock closed in that range. If the stock closed the night before at 50, gapped at the open to 55 and then closed at 59, that’s a sign of not only a change in perception (the gap) but also persistent buying after the news (the advance during the day). To be clear, I’m not THAT into intra-day movements, and if a stock doesn’t surge during the day, it’s not a death knell. But a wide-range bar on the chart is a positive.
Fifth: And probably most important: know where a stock is coming from when it gaps. A stock that’s in a sharp downtrend that gaps up has probably bottomed, yes, but it’s also unlikely to really motor higher-it’s more likely to consolidate. Conversely, a stock that’s been running higher for many weeks and then gaps on earnings is also a riskier bet; perception is already sky-high, and thus, a strong earnings move isn’t a game-changer.
For more updates on momentum stocks as we approach the start of earnings season, consider taking a risk-free subscription to Cabot Top Ten Trader.
What stocks are you watching going into the next earnings season?
This post has been updated from its original version published in 2014.