Global Outlook

Earnings Season

Contributed by eResearch

By Bob Weir

Q2 earnings announcements are now in full swing. The market seems to be relying, almost exclusively, on these earnings pronouncements being good, and thus being the catalyst to propel the market forward.

The major North American indexes are stuck just under their critical 200-day Moving Averages. A slate of good earnings should cause the indexes to get back on an upswing. A chorus of poor earnings could provide downside risk.

Talking about earnings, one of our Subscribers sent me an interesting article on post-earnings drift. This interesting concept was first espoused in a brief written by R. Ball and P. Brown in the Journal of Accounting Research, Autumn 1968, pp. 159-178, and entitled “An Empirical Evaluation of Accounting Income Numbers”. There has been additional literature on the subject by other authors.

Essentially, what the researchers found was that when a (major) company reported earnings that were a surprise (either to the upside or downside) in comparison to analysts’ expectations, the company’s stock usually made a large move in response to the surprise in the days immediately following the announcement. But, more importantly, the researchers found that the stock continued to “drift” in the same direction for weeks, even months, afterwards.

This has major implications for the timing of stock purchases. What it means is that an investor can profit considerably by buying shares of companies that make earnings announcements that “Surprise”. The tricky part is determining the extent of the Surprise. These days, the Surprise has to be really significant. Too often companies beat analyst expectations by a few pennies and the stock declines. So the Surprise has to be a real and meaningful surprise.

The stock continues to “drift” in the same direction because it takes analysts a while to digest the Surprise and recalculate their now-revised earnings expectations, not only just for the current year, but also for those following.

Of course, not all stocks continue to drift. They may make a move in that first week, then stay flat or range-bound until there is confirmation that the Surprise was not just a fluke. By the way, the Surprise does not have to be earnings. It could be top line. Or, management could raise “guidance” considerably.