Schaeffer's Trading Floor Blog

The Best Gauge of Earnings Is…

Post-earnings price action tells a better story than whisper numbers

by 4/9/2013 7:52 AM
Stocks quoted in this article:

Earnings Season is upon us!

It's always The Most Important Earnings Season Ever, and this cycle is unlikely to disappoint. It promises to tell us exactly how the economy will look going forward for the next 10 years. Either that or it's just a bunch of carefully managed numbers almost always designed to please analysts just enough. Probably the latter... But hey, it adds a little volatility to the market, so it's generally helpful.

The biggest number to ignore is the overall percentage of S&P 500 Index (SPX) stocks that "beat" the number. It's always about 70%, give or take. It's meaningless. I'd probably disregard "whisper" numbers as well. They're better than published estimates, but still don't tell the whole story.

What does tell the story? Price action after the announcement. That's literally The Truth and the best gauge. Clearly, with the market near highs, expectations are generally on the positive side. So, it will be interesting to see whether ostensibly good news gets positive action in stocks.

I look more for the magnitude of the post-earnings moves and how it relates to the expectations. Options in most high-profile names get bid up in implied volatility (IV) terms ahead of the earnings releases. Once the number comes out, the IV drops. We can measure the magnitude of the expected move by comparing the pre-earnings IV and estimating the post-earnings IV. In the old days, we had to do it ourselves; now, basically every trading service calculates it for you. On TD ThinkorSwim, for example, it's under the label "MMM" (for "Market Maker Move") on the trade screen.

The magnitude of an expected move is simply a Standard Deviation. If the bid up is correct, there's a 68% chance the stock will move less than the expectation. It's important to observe whether too many, or too few, stocks outperform the expectations of the options market. It gives a clue as to whether options on future names are too high or too low.

Last cycle, it was a very mixed bag. Every high-profile disappointment like Apple Inc. (NASDAQ:AAPL) seemed to balance out with a high-profile beat like Google Inc (NASDAQ:GOOG). We never got much of a trend.

As to predicting direction, it's tricky. If call volume and open interest spikes into a name that has acted poorly over the last quarter, I tend to think that's a fade. If everyone's looking for a turnaround, it's probably not happening just yet. Same theory on excess put open interest into an uptrending stock. If the option order flow is consistent with the move in the stock, i.e. a spike in call interest in an up name, I tend to not pay it much heed.

Anyway, the weather's getting nice, baseball's here, earnings are about to come out, so enjoy Spring.

Disclaimer: The views represented on this blog are those of the individual author only, and do not necessarily represent the views of Schaeffer's Investment Research.


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