Earnings and cockroaches

The earning season is now in full swing and you see lot of volatility. Good earnings are immediately rewarded and bad earning or slight miss or guidance lowering is swiftly punished. There are many traders who advise staying away from the earnings season. But if you want to develop a long term and substantial edge in trading, understanding earnings might be one of the ways to do it.

My most profitable strategy is based on trading earning and sales acceleration. I have been closely tracking earnings for past 25 quarters or so. Many sector trends become very apparent during the earning season.

Some of the most powerful and enduring trends lasting months or years are set in motion by earning acceleration or deceleration. The oil stocks started showing significant earning acceleration two and half years ago, which was followed by significant price growth. Look at EBay, an earning miss many quarters ago precipitated a long down slide. Look at Chicos (CHS), after several quarters of god earning and exceeding earnings, a miss in one quarter ended a long running up move( which had started in the middle of severe bear market with earning acceleration). Earnings and sales growth are the fuel which drive prices high in most stocks.

There is a well known theory called cockroach theory to explain why the market behaves in such a manner to earning news. The cockroach theory holds that just as you rarely find one roach in the cupboard, you will rarely find a single earnings surprise, good or bad. Behind the theory is the idea that an earnings surprise can often signal a change in the long-term outlook for future earnings.

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