Earnings Season and the Cinderella strategy

Currently we are in a earnings season and that offers lot of opportunities for profit. 

Behind every major move is a earnings acceleration. 

The earning season provides you with the ability to identify such stocks. 

Stocks react vigorously to earnings acceleration.

After a few quarters of earnings acceleration, every one notices it and the reaction is more muted as the earnings get discounted.

While there is a vast effort by many speculators to anticipate such earnings acceleration and take positions in anticipation, even if you react to earnings and enter after the earnings announcement, you still can catch bulk of the move.

Typically first earnings acceleration is followed by more earnings acceleration or the improved earnings continues.

The structural factors which contribute to earnings acceleration do not disappear in one quarter. That is why earnings trends persist and price trends persist.

When companies announce earnings, if the earnings are significantly better or worse than market/analyst expectations then the company stock goes up or goes down.

This is well documented phenomenon in the market and it is called PEAD or Post Earnings Announcement Drift.

PEAD is 40 year old concept

Ball and Brown in 1968 first documented the PEAD anomaly. 

As its name suggests, the PEAD is the tendency of stocks that beat earnings expectations to continue to drift upwards after the announcement, or likewise for stocks that miss earnings to continue to drift downwards. 

What does the study show. it shows that if you form 10 portfolios of stocks ranked by their earnings surprize then the portfolio of stocks that are in top 10% by earnings surprise outperforms the 9 other portfolio and similarly the bottom decile portfolio under performs the nine other deciles. 

This is the most researched topic in financial field. Every year at least 50 new papers are published on PEAD and is persistence.

1989 more research on PEAD


In 1989 a paper was published (Bernard, V. and J. Thomas, 1989, "Post-Earnings-Announcement Drift: Delayed Price Response or Risk Premium." Journal of Accounting Research. Vol 27 Supplement 1989, 1-36) which further enhanced the study of PEAD and demolished much of the objection of efficient market theorist to PEAD. 

Bearnard and Thomas work is considered one of the most definitive work in this field.
PEAD generates 6.3% abnormal return in 60 days


As is customary in all finance research designs, the author form deciles based on each event’s standardized unexpected earnings (SUE).

 This means that the highest decile contains the stocks that beat expectations the most, while the lowest decile contains the stocks that missed estimates by the most. 

The authors confirm the results of prior work, namely that going long the highest SUE decile and short the lowest SUE decile would yield abnormal returns of 6.3% in 60 days or 25% annualised. 

They also confirm that there is an inverse relationship between firm size and resulting drift.
What you need to know about PEAD


PEAD phenomenon is more pronounced in thinly traded stocks.

PEAD phenomenon is more pronounced in stocks with no analyst coverage.

PEAD returns persist even after one quarter.

PEAD is more pronounced on stocks with revenue surprise in addition to earnings surprise

Earnings expectation cycle

Merrill Lynch quantitative strategist Richard Bernstein in his book Style Investing: Unique Insight Into Equity Management  offers a very useful conceptual framework for understanding the role of earnings and earnings expectations in stocks price growth. 

Bernstein's earnings expectations model compares earnings expectations of a typical company on a clock face.

When a company is at its pinnacle in growth term it is at 12.00 midnight. In his book he offers a strategy to identify stocks early enough in their growth cycle.

 The idea is to find growth stocks early enough but not to overstay the party. 

That is why the name Cinderella strategy- you should not overstay the growth party and must leave the party before midnight. 

The strategy basically offers a choice of value investing or growth investing based on how early you identify earnings potential of a stock.

12 to 3

12 o’clock: The company’s earnings are high and expectations are also very high
1 o’clock: Torpedo is a negative earning surprise
3 o’clock: Analysts revise earnings estimates downward. Growth investors abandon the stock.\

This is where short selling strategies work. 

3 to 6 

4 o’clock: Earnings expectations continue to fall dramatically.
6 o’clock: At some stage earnings expectations reach their low point. At this point most of the bad news is priced in. Expectations are at lowest level. Contrarian investors focus here.

6 to 9

6 o'clock:This is where value investors focus. Value investors want to buy stocks neglected by market but which have the potential to surprise on earnings front. They want to buy it before the earning surprise. One of the risk of value approach is if you buy too early, you have to wait a long time.
7 o’clock: Stock has a positive earnings surprise. If it is a genuine turnaround there will be more surprises down the line.
9 o’clock: Market starts to recognise the stock and its earning potential.

9 to 12
This is where primarily growth investors focus. They want companies that have exhibited consistent earnings growth over several quarters. They pay premium for such stocks as the stock has already moved from low expectations to high. The value investors pass on these stocks to growth investors during this transition phase. The risk of growth investing is overstaying the party beyond midnight.
11 o’clock: Everyone becomes aware of the company.
12 o’clock: Earnings and earnings expectations reach peak.

The CANSLIM strategy primarily operates in the 9 to 12 quadrant. 
That is one of the reason many of the stocks on IBD 100 can break down also after appearing in the list. 


Earnings lead breakouts operates primarily in the 6 to 9 quadrant. 


Building a mix of earnings based strategies in the 6 to 12'o clock time frame gives you best of both worlds.


Mark Minervini's SEPA

If you go to Mark Minervini's site and look at his SEPA model, he illustrates this fact with a picture. This model is very similar to Bernstein's model.

Mark Minervini's SEPA model

Earnings surprize and neglect are two essential elements to finding the big movers. 

Every earnings season these two things come together to create mispriced opportunities. 


If you want to profit from that then look for big earnings surprizes. 

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Earnings breakouts

It is earnings season. Market might have been weak, but stocks with earnings surprise still  had positive response:

ALGN
DLX
EK
GMCR
NFLX
NOK

Earnings season is season of opportunity if you know what to look for in earnings.

Mark Minervini on Earnings

Mark Minervini the highly secretive trader featured in Market Wizard  has started a blog and he has been talking about his method and offering some picks.

His two recent posts on earnings are good read.
Earnings Part1
Earnings Part2 

25 stocks with momentum

After few weeks of selling, there has been some churn in the the top ranked momentum stocks. But many have survived the selling without much damage and have had orderly pullback or sideways move.
Once the market bounces back many of these will be first to breakout.

ASYS
BARE
CNU
CYTX
DAL
EWBC
HPJ
HUSA
ICOC
LYV
MAPP
MMR
MNI
MSPD
REV
SANM
SEED
SORL
SPRD
SWSI
TRGL
UAUA
WPZ
XTEX
XTXI

What is market breadth telling us

Market Monitor

	Market Monitor Market Monitor is market breadth based market timing tool		Current View Cautious Mrket has given up early gains 2 days in a row. Which is a sign of weak market.
Type	Indicator	Value	Comments
Daily	# of stocks up 4% plus on high volume	102
Daily	# of stocks down 4% plus on high volume	168	Another negative day
Primary	# of stocks up 25% plus in a quarter	916
Primary	# of stocks down 25% plus in a quarter	389
Secondary	# of stocks up 50% plus in a month	3
Secondary	# of stocks down 50% plus in a month	1
Secondary	# of stocks up 25% plus in a month	51
Secondary	# of stocks down 25% plus in a month	30
Primary fast	# of stocks up 13% in 34 days (bullish)	981
Primary Fast	# of stocks down 13% in 34 days (bearish)	1066
MMA+	% of stocks above their multiple moving averages	37
MMA-	% of stocks below their multiple moving averages	25
10 day cumulative breadth ratio	Ratio of socks up 4% to down 4% in last 10 days	0.64	Approaching .5 Below .5 is bearish

Trading preparation checklist

1	What is your market bias for today? Is there a plan to exploit it? Is there a alternative plan?
2	What homework have you done for trading today? What are 2-3 pre identified opportunities? What is your plan for each open position?
3	What is working in the market currently? What sectors are leading the market? What style is working (growth, value, momentum, contrarian, junk)?
4	Are you set up for trading today? Is your hardware in proper condition? Are your software's set up for trading?
5	Are you calm, excited, harried, or confused? What can you do to be in calm and controlled state? What is driving your emotional state
6	What is your plan today for enhancing your: market knowledge your trading skills your psychological control
7	What needs to happen for me to be a confident and in control trader Do I have resources to get there? Do I have the burning drive to get there?

Watchlist for Monday

In the short run bounce might be most probable move. But bounce will likely fail. So many strong stocks will rollover.
Will be watching these for possible rollover:

• ewbc
• dal;
• cqp
• teso
• sanm
• apl
• mmr
• uaua
• stxi
• stex
• swsi

A 10% plus correction would be good

• The market has not had 10% or more correction for months.
• If this develops in to a proper multi week/multi month correction it would be good.
• Correction seperates strong multi month leaders from speculative stocks.
• With a 4th down days in last 6 to 7 days, this looks like a correction.
• But so far betting on correction in this market has not worked.
• Most corrections have been minor and the buy the dip strategy has worked.
• The "International Leaders" seems to be the first to break. 
• That ties in very well with the IBD starting a new page about them.

10 stocks likely to breakout today

1. hpj
2. seed
3. pcx
4. nep
5. mspd
6. sorl
7. dan
8. nvmi
9. mni
10. tstc (this could have been a buy today)

Understanding types of memories

To become a better trader you need to understand our memory and how it functions. If you understand how memory works, you would learn trading much faster.

 

Types of memories:

 

1. Short term memory or working memory
2. Long Term Memory 
   1. Explicit
      1. episodic
      2. semantic
   2. Implicit
      1. Procedural memory
      2. Priming memory

 

There are two basic types of memories: long-term memory and short-term memory.

 

Short-term memory is also called working memory.

 

Short-term memory is where most of the learning happens.

 

Long-term memory is primarily used for storage.

 

When we learn something it is stored in long-term memory.

 

The two types of long-term memories, explicit memory and implicit memory.

 

Explicit memories also called conscious memory.

 

Within explicit memories there are two types of memories: episodic memories and semantic memories.

 

Episodic memories deal with specific events and their context, for example your first date memories are stored in episodic memories.

 

Semantic memories deal with the knowledge about the world, for example what is the capital of Uganda is stored in semantic memory. Most books on trading deal with semantic memory.

 

Implicit memories is unconscious memory. Implicit memory is where automation happens. Implicit memory is where procedural knowledge is stored.

 

Expertise in trading is primarily about developing implicit memories or more specifically procedural memories.

 

Implicit memories are very difficult to verbalize. 

 

The contents of procedural long term memory cannot verbally be explained. (Can you explain how you ride a bike?)

Performance of activities or demonstration of skills is the only method to convey procedural long term memory.

This is why the new traders are often frustrated.If you want to change your trading behavior  you have to change your procedural memory.

That is true not only of trading but also of life in general.

I'll have more details about procedural memory and how to train it tomorrow.

Stocks likely to breakout today

1. nvmi
2. nep
3. tstc
4. gfre
5. seed
6. caas
7. hpj
8. dan
9. xtex
10. uaua

What color is Dan Zanger's underwear

To trade profitable you need a method and a setup. In the beginning you have very little understanding of the market and how it works and what is a good setup and what is not a good setup. In stock market there are so many different setups used by people. Some of it is pure voodoo and some actually works. The easier solution for it is to model your trading on someone with big returns.

Dan zanger converted 11000 in to $18 million in 18 months

That is a return of 164000%. Before doing that he had blown up his account many  times he claims.

If we study in detail what was the secret of his astounding returns then we may be able to generate good returns.

Following someone who makes 10% in a year will at best make you 5% in a year, better buy Index fund and retire from trading.

If you have to model your method you might as well do it on someone like Dan Zanger.

That was my thinking so I studied in microscopic detail every single thing about Zanger and his method during his explosive returns period.

Since then he has changed his method a lot as he trades larger account.

Dan Zanger talks a lot about chartpatterns

In fact the name of his website itself is www.chartpattern.com . So did he discover some amazing and secret chart pattern?

If it was so you just have to find that pattern and trading is very easy.

What really is the pattern that made him 18 millions.

There are obvious answers. But remember things are not always as they look.

Chart pattern is small part of the Dan Zanger mystic.

The surprise behind Dan Zanger returns

In fact if you study very carefully the history of his trading during his explosive returns phase , you would instantly recognise the role of earnings and earnings announcements in timing of his entry.

In the initial years, it would be all about low float stocks which has announced 100% plus kind of earnings. He would enter based on earnings plus chart patterns.

Those stocks make those blowout moves because of earnings and low float.

Now with bigger account he has started focusing on large caps with earnings.

Chart pattern is part of the story but the basic fundamental reason for those moves is very important.

The 400 stocks he monitors stock patterns on and trade are all with extremely high earning growth or momentum.

Dan Zanger is a momentum trader

The second thing you will realise is that he basically selects momentum stocks.

The stocks he trades have price and sector momentum.

He looks for chart pattern on those kind of stocks.

His most often highlighted patterns are bull flags and triangles.

Besides that he talks of 10 patterns on such stocks with explosive earnings and momentum.

Dan Zanger used to trade small  stocks

When he made 164000 returns most of his trades were on small float stocks.

Stocks with less than 25 million float.

Many had less than 10 million float.

Most traders trade too big a float stocks. Unless you are a day trader , you should not trade big float stock.

Big float stock have very low probability of making big explosive moves.

If you have small account you have tremendous advantage in trading small float and small cap stocks.

Smaller stocks have greater variability in earnings growth due to their size.

So a small change in business climate can lead to sudden jump in earnings.

That results in big explosive move.

Dan Zanger used to bet the farm on big ideas

If he had a big idea he would load up like crazy.

He would often have his full account in one idea.

In the market there are plenty of small 20 to 30% kind of ideas, but once in a while you find a perfect  idea with explosive potential, that is where you can really make big money.

But to bet big and that too on margin requires confidence in your skills and ideas.

Dan Zanger was a IBD follower

Dan Zanger in one of his interviews said he has read William O'Neil's book more than 100 times and he continues to read it every now and then.

If you study the people who have made big returns in the market, you will find again and again the same thing: most of them are growth investors.

Only growth stocks make big explosive moves during their hyper growth phase.

What color underwear does he wear

This is just topline highlights of his method.

If you study his method in detail you can fill up over 200 pages of notes.

If you are looking for developing a method to find such explosive stocks you need to do your own detailed analysis of his method .

Find out every single detail about his method.

If the  secret behind his explosive returns is red Gucci underwear, then wear it and trade.

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36 stocks with momentum

AEZ
ATHX
BIOF
CAAS
CFI
CTEL
CYTX
DAN
EXXI
FSII
GFRE
GKK
HPJ
HUSA
IDN
LUNA
MIC
MMR
MNI
MSPD
NEP
NLST
NVMI
ONP
PCX
PWER
RXII
SEED
SMI
SORL
SWSI
TGB
TSTC
UAUA
WNC
XTEX

If market corrects here then there will be lot of churn in this list. Stocks which survive in the list post correction would be fist to breakout.

How to develop trading exprtise

The primary challenge in trading is of expertise development. To trade profitably, you need an expertise in a particular setup. If you want to trade Episodic Pivots successfully then need to become an expert in it. Or if you want to trade IBD 200 method or momentum trading you need to become expert at it. Trying it out or couple of days does not make you an expert.

If you understand the process involved in becoming an expert than you'll find it easier to become an expert.

What is an expert

Layperson uses the term expert loosely to describe anyone with superior knowledge or skill. 

Psychologists use the term expert  to refer to an individual who is significantly more experienced than others in performing a particular task. 

Expertise is task specific.

How do expert develop such expertise?

Psychologists have studied expertise development and experts in various fields and today there is a very good understanding about what makes an expert a expert. 

Psychologists have found that expertise is developed through encapsulation.Encapsulation is a process whereby the adult learner's cognitive energies and skills become focused on a specific areas. 

The outcome is cognitive efficiency. As a result of the process new ways of thinking develop in the brain. Brain becomes extremely efficient at performing the task. 

There are  many  differences between experts and novice

The difference between experts and novices cannot be reduced solely to experience.  There are at many qualitative differences between experts and novice.

Novices rely on formal rules and procedures to guide them. Experts rely to a greater degree on their accumulated experience. 

Absence of such a accumulated experience creates problem for novices, this problem can be overcome by studying historical examples.  If you study thousand examples of past swing trades or Episodic Pivots trades then you will have a better accumulated experience. 

As a result of such deliberate study next time when you are taking a trade you will bring the accumulated experience of 1000 plus trade to your trade. 

Reduce the load on cognitive process 

Novices are highly conscious of the task performance process and the rules involved in performing the task. This task consciousness creates a load on cognitive process. 

The cognitive load theory shows that humans have very small short term memory. So when they try and do complex task where they have not yet acquired expertise, it leads to cognitive load. They are trying to remember steps or sequence or method rules. This is a distraction and creates additional "load" on cognitive processing. 

That is why they become frustrated, harried, or lack confidence. As expertise grows, performance of the task becomes automatic. This cognitive phenomenon is called "automaticity." 

In trading terms when a trader tries to trade a method like say IBD 200 after reading the guidelines here, he soon encounters cognitive load. He is trying to remember the steps without sufficient practice and thinking. He or she spends great deal of time on smaller task. As a result gets frustrated. 

Understand the cognitive load theory

Understanding the cognitive load theory is very critical if you want to become a consistently profitable trader. 

Human brain has short-term memory and long-term memory.  All learning happens in short-term memory. once learning happens, it is stored in long-term memory.  

When information is stored in long-term memory, it is stored as chunks. And when this information is recalled,  it is also recalled in chunks. This is the reason why somebody who is an expert takes many factors into consideration in a single decision. 

 As expertise is acquired, the learner's cognitive processing system becomes more efficient at processing new information. As a result, experts can see the whole picture. They are also more aware of the specific circumstances in which they are working. They have good self-monitoring skills. Experts can make even very complex, difficult tasks look easy. 

Experts use larger number of strategies

The expert has a larger number of strategies, and more effective strategies, for performing the task. This may be the most critical difference between the expert and the novice. 

Experts  have multiple strategies for dealing with the unexpected things and change of circumstances. This is the X factor. You develop this if you spend significant effort immersed in a task. 

In trading terms expert trader takes more factor in to consideration on a trade. He is aware of overall market, sector moves, phase of market, what style is working and what is not working and so on. While novice focuss on few variables.

Trading from the gut

Experts are more flexible than novices. They rely on intuition in ways that novices find difficult to comprehend.

Recently Curtis Faith came out with a book called Trading From Your Gut . The book deals with such issues in detail. 

Those who are serious about their trading will find his book very interesting. 

Many novices will find it difficult to understand or fail to grasp the significance of it.

 

How do I become an expert in a specific trading strategy

For a beginner trader that is the big challenge. If you want to be a successful trader you should be conscious of these processes. Study the psychology of expertise. 

If you understand the process involved in becoming a expert, you will approach your learning very differently. You will consciously follow a learning path that will lead to developing a trading expertise. 

That kind of approach will lead to life long skill development. 

First find a good setup

Expertise is task specific. So defining a specific task to become an expert at is very critical.

The first step in becoming a good trader is to arrive at a tradable setup. And then become an expert in trading that particular setup.

 In the initial phase when you're not very clear about which setup to trade,  you must look at all possibilities. 

Look at all possible options  like day trading, swing trading, position trading, macro trading, options, futures, currencies, and so on. 

Once you cast your net wide, you'll find many possible setups.  

Find a setup that suits your personality

Then you have to  decide what kind of setup suits your personality. Charles Kirk in his Twitter feed highlighted a post by Tim Knight of Slope of Hope yesterday about this. 


Tim Knight wrote a post  Finding Your trading style , that goes to the heart of the matter. He predominantly trades a bearish setup because it suits his style and personality. 

You can only trade what you believe in and what suits your style. 


Some people are inclined to growth, some are inclined to value, some are inclined towards momentum and so on. 


You have to find your style. 

Setup should also suit your capital

Even if a setup suits your personality, it should also suit your trading capital. 

Certain types of trading require large capital.  Certain types of trading is best done in a professional environment.  Certain type of trading is more suitable for small and medium-size accounts.  

Macro trading is suitable for very large accounts. Trend trading is not suitable for small accounts. Swing trading is more suitable for smaller accounts.

Or if you want to become a daytrader it is best to join a professional firm. 

Once you decide on a particular style  and a setup.  Then you must become an expert in that particular style.

Become an expert in a setup

To do this successfully you need to go into depth. If you want to become a good swing trader go into depth of swing trading.

Grab hold of every single piece of information available on swing trading. Study swing trading styles of different traders. Get in to microscopic detail of swing trading. Exhaust all learning sources on swing trading. 

Then design a strategy or model year strategy on someone else strategy.Then trade it consistently for a long period of time. if you do that then only you'll develop expertise.  

Most traders change their style so often that they never become an expert. They are constantly trying out new styles. 

Not everybody has the time and inclination and motivation to do this successfully. That is why they say in trading profession many are called but few are chosen.

The path to being a profitable trader is the expertise development path. 

Next: What color is Dan Zanger's underwear

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