How I’m Navigating The “Earnings Game” Right Now…
For the first time in a while, I made no trade recommendation this week over at Income Trader. And the reason is simple: my award-winning ITV system did not find any suitable candidates. And when a system helps you produce a track record of winning trades better than 90% of the time, you follow it.
For anyone who has been with us for the past few years, you know that this will happen occasionally. It’s a result of my conservative approach to investing. But it also speaks to the unique time we’re at in the market right now…
A Risky Time In The Market
Between now and the end of next week, almost 300 companies in the S&P 500 index will report earnings. Earnings per share (EPS) is expected to decline by 44% compared to the same quarter a year ago. If analysts are correct, this could be the worst quarter since Q4 2008 — in the middle of the Great Recession — when EPS fell 69.1%.
EPS isn’t the only metric expected to see a crisis-sized decline. Year-over-year revenue is also expected to drop by 10.5%… the biggest drop since Q3 2009 when revenue fell 11.5%.
Companies are also expected to report a sharp decline in their net profit margins. Profit margins are the ratio of earnings to sales, a measure of how much profit a company earns per dollar of sales. Analysts expect a profit margin of 7.1%, down from 11.5% a year ago.
The chart below shows that the trend in prices (green line) tends to track the trend in profit margins (red bars).
Source: Standard & Poor’s
Now, because the decline in profit margins is due to the economy shutting down in response to COVID-19, analysts expect to see a quick rebound. FactSet reports that analysts expect a margin of 10.1% in the first quarter of 2021.
That 2021 rebound is based on the United States seeing rapid economic recovery. Personally, I think that sounds optimistic. Data on COVID-19 indicates optimism might not be warranted.
Source: NY Times
The “Earnings Game”
I believe that the rising trend in new cases is a reason for us to wait for earnings before entering new trades.
Even so, I still believe many companies will beat expectations. That’s because of a process that can be called the “earnings game.” The earnings game occurs once every three months, with each “game” split into two halves.
In the first half of the game, analysts speak to management teams to come up with estimates for the quarter. As we move closer to the reports, analysts revise their earnings forecasts. Generally, they revise estimates downward after these discussions.
In sports terms, if this were a hurdle race, they would be lowering the bar. At the beginning of the quarter, the bar is about waist high. By the end of the quarter, the bar is just above the ankles.
Over the past three months, analysts cut their earnings estimate by 34.3%. Estimates are 49.7% lower than they were a year ago.
In the second half of the earnings game, companies report earnings. Many — on average about 72% of companies reporting in a quarter — beat expectations. When this happens, the underlying stock jumps on the better-than-expected results.
How The Game Plays Out
We’re currently heading into the second half of the earnings game, and analysts will be surprised that many companies are beating estimates.
But not all companies will be so lucky. There will still be a number of companies that do not beat estimates, and the stocks of those companies are likely to sell off on the news. We could also see selloffs in stocks of companies that beat expectations if management issues warnings about the current quarter.
That means risks are high this week. And that’s why I was unable to find a trade with low risk in my scans of the market. But I don’t expect this to continue for an extended period. As risks decline and we gain insights into earnings, there will be new ITV signals. And there should be a trade next week.
So bottom line, whether you follow my trade recommendations over at Income Trader or not, I recommend exercising caution on any trades you make right now.
Editor’s Note: My colleague Jimmy Butts recently found something else that could make you a fortune in 2020…
While digging through SEC documents, he found a small item in the filings of a little-known satellite technology company. And the implications are huge…
It turns out this company paid a measly $26 million for a tech startup it bought in 2019. That’s an amazing price, but it’s just a small fraction of what they received for their $26 million. And it could amount to the most lucrative opportunity we’ve come across in years…