How to trade the earnings season

The new earnings season starts this week. Every earnings season leads to new leadership developing in market. There are always some stocks that have significant earnings surprise either to upside or downside. Such earnings surprises lead to rallies in such stocks.

PEAD (Post Earnings Announcement Drift) is a very well known and extensively studied market anomaly. Ball and Brown first documented the PEAD phenomenon in 1968. Since then hundreds of thousand studies have confirmed their findings across world markets.
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 Ball and Brown and similar 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 decile.

Everyday during earnings season number of companies surpass earnings expectations or miss earnings. When earnings is announced it is compared to existing expectations. Iif the earnings is a major surprise to the market then the stocks reacts immediately to that news. Most of the time the stock with significant earnings surprise will make 8 to 40% move on earnings day itself. Depending on market conditions these stocks can go in to multi week rally. In uncertain market conditions, they tend to pullback and go sideways or form range and then breakout nearer to next earnings.

When looking for PEAD candidates , stocks with first or second significant earnings surprises and significant earnings growth lead to big moves. After a few quarters of earnings acceleration, everyone notices it and the reaction is more muted as the earnings get discounted. Very few stocks can consistently surprise on upside for more than few quarters.

Market reaction to earnings miss is often brutal if the stock has high expectations built in to price and has rallied for many quarters based on good earnings. Any miss on such stock can lead to big gap down. This makes holding stocks during earnings season a high risk venture.

While there is a vast effort by many institutional speculators to anticipate such earnings acceleration or deceleration and take positions in anticipation, for small speculator the edge is in small , unknown stocks that no one is following. In these stocks the earnings effect is more pronounced. In these stocks even if you react to earnings and enter after the earnings announcement, you still can catch bulk of the move. Getting in to these stocks takes away the headline risk.

There is a cockroach effect in earnings trends. One earnings surprise is typically followed by many more earnings surprises. When you focus on first earnings acceleration there is good chance your stock will have more such earnings. So effort spent in researching stocks during earnings season can pay you off for many quarters. The structural factors which contribute to earnings acceleration do not disappear in one quarter. That is why earnings trends persist and price trends persist.

During this earnings season paying attention to stocks that have significant earnings surprise or miss can give you a good head up on future leaders or laggards.

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