When It Comes to Earnings, Expectations Are Key

Pre-earnings sentiment can affect the post-earnings behavior of a stock, as we saw with Apple Inc. (AAPL)

Jul 14, 2016 at 4:39 PM
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When combined with fundamental and technical factors (a 3-tiered methodology we call Expectational Analysis®), sentiment becomes a powerful tool for analyzing stocks, sectors, or the overall market. This is especially important as earnings season ramps up. 

A quarterly earnings report details a company's finances by breaking down revenue, profits, costs, and other important financial metrics for shareholders and analysts. Earnings reports also often provide a full-year fiscal outlook, as well as anticipated risk factors for the firm or sector in general, providing a glimpse into a company's strengths and weaknesses -- a fundamental report card, so to speak. However, contrarians know that pre-earnings sentiment -- or expectations -- can affect the post-earnings behavior of a stock. 

Generally, when earnings beat analyst expectations, the stock will swing upward, while weaker-than-expected top- or bottom-line figures will often lead to losses on the charts. So, even if a company reports 100% year-over-year (YoY) earnings growth, the underlying stock could still drop if expectations were for a 200% YoY profit. On the flip side, if a company says revenue fell 50% from the previous quarter, the underlying stock could still rise in the face of very low expectations. 

For example, if analysts are very bearish on a stock ahead of earnings, and the company posts a surprise quarterly profit, a slew of subsequent upgrades could add fuel to the shares' post-earnings fire. On the other hand, if analysts are extremely "buy"-heavy ahead of earnings, a surprise per-share earnings loss or lackluster guidance could trigger downgrades, exacerbating selling pressure. 

Short interest can also play a role. If a firm reports stronger-than-expected earnings, or issues surprisingly upbeat guidance, shorts could get squeezed as the underloved stock muscles higher. A short-covering rally could ensue, as bears rush the exits.

Likewise, if option buyers are more put-heavy than usual ahead of earnings, a positive earnings surprise could lead to the unwinding of these bearish bets, pushing the stock higher. On the flip side, an earnings miss could fuel an exodus of option bulls.

Apple Inc. (NASDAQ:AAPL) has served as a real-world example of how sentiment can affect post-earnings behavior. Prior to delivering earnings in April, analysts were extremely bullish toward AAPL. After delivering an earnings report that came in short of expectations, AAPL saw almost-immediate downgrades, and received price-target cuts from over a dozen analysts. Just days later activist investor Carl Icahn sold off his AAPL shares, helping to push the stock to its longest losing streak in 18 years. Even months later, AAPL hasn't been able to fully close the post-earnings bear gap, and currently sits down 5.6% from its pre-earnings price of $104.35.

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