This Earnings Season Is A One-Of-A-Kind Opportunity

This Earnings Season Is A One-Of-A-Kind Opportunity
Carl Hazeley

almost 3 years ago4 mins

Mentioned in story

What’s going on here?

Earnings season is always a busy time for investors: most have just rebalanced their portfolios and are therefore willing and able to take advantage of new opportunities. Lucky for them, then, that this quarter’s upcoming updates may well offer a shot at once-in-a-lifetime levels of profit from short-term “tactical” trades.

What does this mean?

Companies’ regularly report how much money they made over the previous quarter and how much they expect to make in the coming ones. These quarterly earnings seasons are important to investors who’re focused on the long term: they offer a chance to check in on whether recent data still supports long-term views, forecasts, and investment cases.

But short-term traders pay close attention to earnings reports too. Stock prices can sometimes move dramatically in response to their release: if a company has performed much better or worse than expected, there are opportunities to profit aplenty. And heading into this earnings season, short-term trading in response to company releases appears primed to pay off much more than usual.

Companies usually try to set expectations for their quarterly profit at a level they think they can beat: such outperformance typically sends share prices up. This means many companies initially encourage analysts with over-optimistic forecasts at the beginning of each quarter which then get lowered in the lead-up to earnings. The average company’s profit prediction falls 4% over the course of a normal quarter.

During the first quarter of 2021, by contrast, company profit estimates rose by 6% on average – the most since 2002. And that was accompanied by rising US stock prices as tracked by the S&P 500 index, suggesting a strong quarter for company earnings has already been “priced in” with little scope for any positive surprises.

S&P 500 index level (R) and average earnings per share (EPS) forecast (L)
S&P 500 index level (R) and average earnings per share (EPS) forecast (L)

What’s more, investors’ own second-quarter earnings estimates are also already high: analysts expect 53% profit growth versus a year ago (although the onset of the pandemic admittedly provides a pretty low bar).

For US stocks, then, there’s arguably an outsized risk of negative surprises this earnings season. If the chances of better-than-expected results and raised forecasts are already reflected in current expectations and valuations, companies reporting just that are unlikely to see their stock prices rise much further in response. But companies missing forecasts or lowering their outlooks could drastically disappoint investors – and certain stocks could be sent tumbling.

Why should I care?

There are two ways you can try to make some profit of your own from this state of affairs: either through stocks directly or via options.

1️⃣ Stocks: Analyzing risk/reward skews

Looking at the sectors (and individual stocks within them) where earnings estimates and share prices have moved the most can help you identify where the risk-reward ratio is most skewed in or out of your favor.

US energy industry stocks, for instance, have been America’s best-performing sector so far this year, followed by financials and industrials – while consumer staples and utilities stocks have brought up the rear.

US stocks’ year-to-date performance by sector (Source: Koyfin)
US stocks’ year-to-date performance by sector (Source: Koyfin)

Contrasting that with where earnings upgrades and downgrades were concentrated last quarter may be revealing. Expectations for energy and financials companies were upgraded the most – but with their stock prices also climbing, the opportunity there may already have passed, leaving the near-term risks skewed to the downside. The same may be true for industrials too: first-quarter profit forecasts for such companies have seen the biggest cuts from analysts, but it’s also been one of the best-performing sectors in terms of share prices.

Consumer staples and utilities companies, on the other hand – the two worst-performing sectors in 2021 so far – have generally seen no meaningful revisions to their earnings estimates. For these stocks, any earnings-season surprises may be more likely to turn out positive.

Earnings estimates by sector

2️⃣ Options: Stock replacement

A more advanced tactical approach to earnings season involves selling your stock holdings in target areas and temporarily buying their equivalent short-term stock call options instead. This strategy theoretically limits your potential losses to the extra amount you pay for the option (a.k.a. its premium) but gives you unlimited exposure to any upside.

With average S&P 500 stock volatility currently sitting at post-pandemic lows, now is also a relatively cheap time to buy options: higher volatility pushes their prices up.

Needless to say, the frequent use of leverage (among other things) makes this a riskier endeavor requiring more research than your garden-variety stock investing. Aside from the option costs themselves – while average volatility is down, that of the individual stocks you’re interested in might not be – be sure to factor in any transaction fees applicable along the way.

There’s also the risk that after selling your shares in order to replace them with options, prices go up – but not enough for you to exercise your options. That may force you to repurchase your original shares at a higher price if you still want to own them.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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