Some of the best investment opportunities happen when pessimism is high. And right now, there is an unusual amount of pessimism hanging over third-quarter earnings season.
That's because for the first time in three years, total S&P 500 earnings are expected to fall from the previous year. Although that's not exactly a devastating blow to the market, it's a signal that economic growth is slowing and that margins are at the top of a multi-year cycle.
Both of these factors have been weighing on sentiment, leaving the S&P 500 with its biggest loss in four months and off 3.7% from a four-year high hit in mid-September. It also put into place a very bearish double top. The last double top we saw was in May, when stocks proceeded to fall 9%.
Take a look below...
S&P 500 Double Top and Pullback
The market has taken a decisively defensive turn after four months of big gains. This refreshed bearishness is going to make this a tough earnings season for many companies. Stocks that miss expectations or guidance are going to be punished harshly. Similarly, the ones that beat estimates are going to be rewarded handsomely. And this is creating a great opportunity to use one of my favorite investment strategies.
Not only is it incredibly easy to implement, this strategy should be particularly hot this earnings season with sentiment running low.
I'm talking about something called the post-earnings drift. The post-earnings drift is the tendency for stocks that produce positive earnings surprises to drift higher during the following 60 days. It's basically a pure momentum play, trading positive price movement and investing in earnings strength.
Companies that beat expectations are sending a big signal to the market about their business. These are the companies that have most effectively managed the unusual amount of economic volatility and still pulled through with big profits. This kind of performance and a confident outlook will be a magnet for fresh capital.
To better take advantage of this strategy, it's also important to understand how capital flows into the market. Big institutional fund managers with billions in the cannon won't necessarily be first responders to the news. These bigger operations may want to review some data and then fire off a big trade within a few days or maybe even weeks. But any individual investor can front-run these fund managers.
And thanks to the post earnings drift, you don't have to worry about sifting through thousands of stocks to find companies that you think will beat expectations. You simply focus on the small number of companies that have already delivered positive results and jump on the band wagon.
Here are three stocks that have already done that early in earnings season.
1. Yum! Brands (NYSE: YUM)
Yum! Brands reported solid third-quarter results in early October, beating estimates by 2% with earnings of 99 cents per share. The only point of contention was Yum! seeing some slower growth internationally, particularly in China. But the company is still seeing solid gains overall, with analysts calling for 14% earnings growth in 2013.
Shares look a bit pricey right now with a forward price-to-earnings (P/E) ratio of 21, ahead of the 10-year average of 18. But according to the post-earnings drift, Yum! Brands is in position to reap the benefits of another solid quarter. Take a look at Yum!'s great year below and how shares popped on the good quarter.
2. Federal Express (NYSE: FDX)
Federal Express also recently pulled through with a nice surprise, beating third-quarter expectations by 3% with earnings of $1.45 per share. Although the company trimmed its earnings outlook on slower economic growth, the company also announced a $1.7 billion cost-cutting plan that the Street clearly liked. You can see that in the chart below, with shares up more than 5% on the news.
Bigger picture, Federal Express has been volatile as an economically-sensitive stock. But with a solid earnings surprise and the post earnings drift in hand, shares are in position to challenge the all-time high less than 12% away.
3. JP Morgan Chase & Co. (NYSE: JPM)
Of all three stocks, JP Morgan logged the biggest earnings surprise, coming in with earnings of $1.40 per share, a nice 37% increase from the year-ago period and easily beating estimates of $1.24 a share. That definitely gave shares a nice boost, but much like Federal Express, Morgan has been volatile in 2012.
But even though the financial sector continues to be plagued by uncertainty and balance sheet risk, Morgan is looking quite solid on the earnings front, expected to make $4.21 per share this year. There is still a drag in financial stocks, however, as investors continue to be cautious. You can see that showing up in the historically low valuation in spite of the company's solid earnings and earnings growth. If Morgan returned to its average forward price-to-earnings (P/E) ratio for the past 10 years of 12, from the current P/E of 9, then shares would jump 33%. Take a look at the volatile year and recent jump in the chart below.
Risks to Consider: Stocks involved in earnings events can overreact to good news, with shares jumping higher than earnings or future earnings warrant. Companies that have seen big gains on an earnings surprise could already be fully valued after jumping on good news.
Action to Take --> All three of these stocks recently reported earnings that came in ahead of expectations. This means the post-earnings drift will likely provide support for shares during the next 60 days. And when you add in strong earnings and compelling valuations, there are even more reasons to be bullish on the group.