Stocks continue to trend higher and are creating a very interesting setup as we head into this week's earnings reports. Most of the major reports this week are banks but the group should provide some insight into what theme may develop as results roll in.
Typically there is some general pattern, such as "buy the bad news," "revenue miss but earnings beat," "lower forward guidance," or any number of excuses and justifications for why results aren't better. Quite often we see buyers jump in quickly when a report appears to be weak, although there are many exceptions.
Most publicly traded companies know how to play the earnings game. They lowball guidance enough so that they will beat, which is why the vast majority of companies will top the posted earnings-per-share estimates. Beating published guidance is not enough to guarantee a positive response, especially when a stock has made a big run-up into its report.
It is important to keep in mind that the trades with the best risk/return ratio occur after the report is released. The volatility that follows a big beat or a big miss can produce the best entry points.
Generally, there is no edge in jumping in before a report is issued. Not only must you try to predict how strong a report will be but you also need to predict the reaction. A good or bad report often doesn't generate the response you might expect.
Charts aren't much help in predicting the response to earnings either. When a stock makes a big run into a report there is a tendency to look for a "sell the news" response but that is not nearly as logical and easy as it may sound. Good charts don't necessarily indicate that a strong report will be forthcoming so extra caution is needed in determining if you want to hold or not.
The great thing about earnings season is that it generates a new crop of opportunities. I am quite certain there will be some blowout reports that will produce the biggest gaining stocks in the quarter ahead.
There is a lot of luck involved in earnings season so don't fool yourself into thinking you have special insight. Make sure you control risk and have a clear strategy.