How markets work

On this page you will find various links to web posts that reveal which factors move stock prices. It provides basic market understanding, a solid foundation to step on. As the time passes, the list will grow and will feature different points of view, which I believe explain the nature of all gigantic equity moves. I created this page to serve me as a personal e-library and basic point for creation of profitable trading methods. If you have a suggestion for a worthy link, let me know in the comments’ section.

Earnings growth – the most powerful catalyst

• The role of earnings and earnings expectations in stocks price growth by Richard Bernstein

Bernstein’s earnings expectations model compares earnings expectations of a typical company on a clock face. When a company is at its pinnacle in growth term it is at 12.00 midnight. In his book he offers a strategy to identify stocks early enough in their growth cycle. The idea is to find growth stocks early enough but not to overstay the party. That is why the name Cinderella strategy- you should not overstay the growth party and must leave the party before midnight.
The strategy basically offers a choice of value investing or growth investing based on how early you identify earnings potential of a stock.

12 to 3
12 o’clock: The company’s earnings are high and expectations are also very high
1 o’clock: Torpedo is a negative earning surprise
3 o’clock: Analysts revise earnings estimates downward. Growth investors abandon the stock.
3 to 6
4 o’clock: Earnings expectations continue to fall dramatically.
6 o’clock: At some stage earnings expectations reach their low point. At this point most of the bad news is priced in. Expectations are at lowest level.
6 to 9
This is where value investors focus. Value investors want to buy stocks neglected by market but which have the potential to surprise on earnings front. They want to buy it before the earning surprise. One of the risk of value approach is if you buy too early, you have to wait a long time.
7 o’clock: Stock has a positive earnings surprise. If it is a genuine turnaround there will be more surprises down the line.
9 o’clock: Market starts to recognise the stock and its earning potential.
9 to 12
This is where primarily growth investors focus. They want companies that have exhibited consistent earnings growth over several quarters. They pay premium for such stocks as the stock has already moved from low expectations to high. The value investors pass on these stocks to growth investors during this transition phase. The risk of growth investing is overstaying the party beyond midnight.
11 o’clock: Everyone becomes aware of the company.
12 o’clock: Earnings and earnings expectations reach peak.

• Earnings’ acceleration by Pradeep Bonde

Behind every major move is a earnings acceleration. The earning season provides you with the ability to identify such stocks. Stocks react vigorously to earnings acceleration. After a few quarters of earnings acceleration, every one notices it and the reaction is more muted as the earnings get discounted.
While there is a vast effort by many speculators to anticipate such earnings acceleration and take positions in anticipation, even if you react to earnings and enter after the earnings announcement, you still can catch bulk of the move.Typically first earnings acceleration is followed by more earnings acceleration or the improved earnings continues. The structural factors which contribute to earnings acceleration do not disappear in one quarter. That is why earnings trends persist and price trends persist.

Earnings acceleration and neglect are two essential elements to finding the big movers. Every earnings season these two things come together to create mis priced opportunities. Even if you follow the IBD 70 plus strategy, you must dig deeper to see if this is recent earnings acceleration or not. Those are the stocks to prefer over other 70 plus EPS candidates. The trick is to buy as close to first earnings acceleration as possible.

Once in a while you get a stock which will continue to have very good earnings growth for very long period of time like 2-4 years, those are the stocks which go on to make 10 times plus moves. Invariably, if you look at those stocks, they would be neglected stock before their first earnings acceleration. Familiar and popular stock can seldom give you major gains.

• Profiting from the earnings cycle

While some stocks languish, companies with superior improving fundamentals can perform exceptionally well. Large institutional buyers (mutual funds, pension plans, hedge funds, etc.) have the greatest buying power to influence a stock’s share price. So, what do they look for? Earnings and sales surprise and estimate revisions contribute to valuation model changes and thus impact buying and selling pressure. The subsequent buying pressure that comes from an earnings surprise or a company materially raising guidance generally leads to a higher stock price, which in turn attracts momentum buyers.

An understanding of how Wall Street works and identifying what specific characteristic will attract institutional buyers into a stock is our daily focus. The graph below illustrates a typical earnings maturation cycle and where we focus our efforts on buying and selling within the cycle:

• The importance of price cycles by Pradeep Bonde

When analyzing EP, catalyst is very important. Prior neglect is the second most important thing. To understand neglect one must understand stock price cycle. It is easier to understand price cycle in context of earnings (there are broadly two types of EP, earnings lead EP and non earnings catalyst EP)

Behind every major move in short time frame or long time frame there is an earnings acceleration. As Boucher says earnings is the fuel which drives stocks. In most stocks earnings are cyclical. What we are most interested is an EP early in the price cycle.

EP after neglect  is best. So when you get an EP list, first you should look at where is this in price cycle. If it is earlier, it is better.

EP’s happening late in price cycle are also good, because they often launch a blowout phase. They are risky, but very profitable. In such cases in just few days you get a 40-50% climax move.

Now from a practical analysis point of view to find a EP at start of price cycle I use 65 days price growth

By filtering with this you get to know which ones are late in price move and which one are early. Similarly filtering on one year growth also gives you idea of price cycle. It is also critical to avoid dead cat bounces, they are typicaly good only for very short duration swing plays.

• Catalysts

“Stock prices are moved by catalysts. There are four major types of catalysts:

1)      Liquidity: low cost of borrowing makes the investment in most asset classes quite alluring. An inflow of money makes price to go up. Rising prices bring joy and confidence to the soul of the masses. Higher confidence leads to higher risk appetite, which usually brings even more money into the stock market. This is a catalyst based on greed and vanity.

2)      Earnings’ related catalysts. If it is not about current earnings (beating estimates), then it is about future earnings (raising outlook above street’s expectations) or potential for future earnings (FDA approval, collaboration with another company, takeover rumors, announcement of new product, regulatory changes that could affect the whole industry). This is a catalyst based on momentum. The key here is market reaction. Reaction no news is more important than news itself…”

• The effect of earnings’ surprises

“When a company has an earnings surprise or a miss, more are likely to follow. That is called the cockroach effect. So when you see one earnings surprise from a company more are likely to follow. That is what produces big trends. When you have one isolated company in a sector with earnings surprise, you can ignore it. But when you have so many companies in a sector coming out with surprise, take note.

Some of the most powerful and enduring trends lasting months or years are set in motion by earning acceleration or deceleration. If you look at any long term trend in stock or sector, you will find at the beginning of the trend a series of earnings surprise or acceleration. The oil stocks started showing significant earning acceleration in 2003 and the trend lasted for 4 years. The steel stocks started showing earnings surprise in 2003 that trend lasted 4 years. So when you have a sector showing earnings surprises take note.”

• Why PEAD works

• Should I trade earnings! by Ivanhoff

“Even during the steepest market’s correction, there are stocks that rise from the dark. They shock the street with their earnings and gap up. Those that appreciate in price during weak markets are potential future leaders and that’s why we should keep our eyes wide open during earnings’ season.”…

• Trading Earnings’ Surprises by Ivanhoff

“Every EPS report reveals new insight into a company operating and financial health. It presents new information that in most cases is not already discounted by the market. It takes time for that to happen. How long? It is different for the various stocks.”…

• Surprise, Surprise by Ivanhoff

“It now takes little more than a day, and often less, for investors to pound a stock down dramatically when bad earnings news is released, compared with the several weeks that were typical in the 1980s, a new report shows. Stocks also rally much more rapidly on good news.”…

• The creation of earnings’ estimates by Ivanhoff

“Steve Reitmeister at zacks.com has interesting comments on earnings estimates’ creation. He claims that there are two main parties that determine an earnings’ estimate – a company executives and brokerage analysts…To understand how these estimates are created you have to know what motivates those two parties…To understand how these estimates are created you have to know what motivates those two parties.”…

• Scratching the surface of an earnings’ report by Ivanhoff

“An earnings’ report provides new information that in at least half of the cases is not already discounted by the market. For what am I looking in an earnings’ report?”…

• Leo Fasciocco’s “Big Earnings Surprise” Approach

“There’s nothing like taking an initial stock position and seeing it start to work for you immediately…I am often amused when I hear TV commentators mention how a stock is up or down, and then they cite earnings that were a penny better or less than the consensus on Wall Street. To me, that is no news at all…Instead, what I look for are companies that report earnings that are better by a significant amount from the highest estimate on The Street.”

• The Surprise Trader letter by zacks

“Our system looks for stocks that were declining into their earnings announcement, but ended up having a big positive surprise.  That means the market was leaning the wrong direction on the stock. So when it turns out to be a positive surprise, it takes investors a couple of weeks to correct their mistake. That’s why we are able to come in after surprises and guide our subscribers to overall gains of +52.8% in less than two years…”

• Trading Earnings’ surprises by Pradeep Bonde

“The Earning lead breakout looks for extreme earnings growth to identify candidates, however on companies with analyst coverage, you can find good results by focusing on companies beating analyst forecast by 100%. The Earning Surprise data appears in the Wall Street Journal daily and you can find it here. Here again I select only companies whose earnings is above 5 cents and which beat analyst forecast by 100% or more…”

• How to trade earnings by Pradeep Bonde

” The earning season is fast approaching. Earning season offers some of the best opportunities for profitable trading. PEAD or post earnings announcement drift is a well studied and proven market anomaly. Stocks which have significant earnings surprise or acceleration, breakout post earnings and rally for next 3-6 months as market reacts to this new earnings power. Sometimes these rallies last years…”

• How to trade earnings Part 2 by Pradeep Bonde

“A variation of the earnings trade is also an useful addition to your trading arsenal. There are a handful of companies which have at any given time very high sales growth. They may or may not have earnings. This happens in biotech, pharma and high technology field. In these kind of companies the sales acceleration acts as a catalyst, kicking off multi month rallies post earnings…

• How to trade earnings Part 3 by Pradeep Bonde

“The stocks reaction to earnings is critical. Three things will happen after a significant earnings 1) immediate breakout 2) no reaction stock continues in range (this might breakout later closer to next earnings) 3) reversal ( this typically happens after a string of earning surprises and significant price growth).

Once you do this for extended period of time you will learn more about how these stocks behave over long periods. You will also get most of the big movers before most people have even heard of them….”

• Bulkowski earnings’ flag by Pradeep Bonde

“Performs best in an upward price trend.When the company announces earnings, the stock makes a large move up or price gaps upward the next day if the market happened to be closed.Look for a near vertical price run, preferably lasting several days.Near the top of the flagpole, price consolidates and usually trends downward. The appearance can be a flag, pennant, or an oddball shape. The best performers are tight congestion patterns, not loose price structures with the stock meandering up and down.A breakout occurs when price pierces a flag or pennant trend line or closes above the high in the pattern (including the flagpole). Don’t trade unless you get an upward breakout…”

• Improving the odds in earnings’ breakouts by P.B.

“This is most important. Low floats ones are the one which really climb out ferociously. Now to trade the low float stocks, you need some understanding of how those stocks trade. In many cases the bid ask spread will be huge. The intra day swings are large. Unless you have stomach for volatility and extremely good risk management, it can be very bumpy ride. The thing to remember is that the earnings catalyst is going to last for some weeks so not getting shaken out of such plays is key. These are the ones which give you the best return…”

• Earnings ans Dan Zanger by P.B.

“Dan Zanger generated a 164000% return, turning $11000 into $18 million in 18 months. Everyone has heard of Zanger’s extraordinary run. Most traders believe that it has lot to do with chart patterns. Chart pattern myth is also perpetuated by him in his many interviews. Chart pattern is one element of his system. There is another element which he often talks about but which many times traders miss and yes you guessed it right, it is earnings.

In fact if you study very carefully the history of his trading and calls, which is their on his subscription website, you would instantly recognise the role of earnings and earnings announcements in timing of his entry. In the initial years, it would be all about low float stocks which has announced 100% plus kind of earnings. He would enter based on earnings plus chart patterns…”

• Trading earnings breakouts by P.B.

“Ball and Brown first described this anomaly in 1968, yet it still occurs decades later. An allegedly efficient market knows of the drift, yet does not take the drift into account in setting prices, thereby driving the drift out of existence. As most traders know if something is known it stops working. However this is an openly available profit making strategy which continues to offer opportunity. Eugene Fama of The Efficient Market Hypothesis fame called the post-earnings-announcement drift the “Granddaddy” of market anomalies…”

Momentum – the strong will only get stronger

• Buying stocks at All time highs by  Blackstar Funds

“For the purposes of this project the entry method chosen was the all-time highest close. More specifically, if today’s close is greater than or equal to the highest close during the stock’s entire history then buy tomorrow on the open. We chose this method to avoid ambiguity. A stock that is at an all time high must be in an uptrend by any reasonable person’s definition. This is a trend following entry in its purest form…”

• The art of swing trading by P.B.

“The concept of swing trading is to trade an upward swing in a stock experiencing a strong uptrend as defined by relative strength or sector stregth. Relative strength is a measure of price trend that indicates how a stock is performing relative to other stocks in the market.

The best points of entry in such stocks are not in the middle of an upward trend, but instead on fresh breakouts after a period of weakness or consolidation…”

Volume matters

• Why volume matters by Brett Steenbarger

“Recall that volume is significantly correlated with volatility. When volume expands in the direction of the trade, it means that you have a correlation of volatility and direction: those are the sweet spots that will give you your best short-term moves. When volume contracts as the trade moves against you, it suggests that volatility is not moving against you, and it can make good sense to stay in that trade.”…

• How can you track the stock market’s Large Traders by Brett Steenbarger

“As a gross distinction, imagine that we have two kinds of traders in the marketplace. The first are market makers (locals) who provide liquidity. They are in the markets throughout the day, and they are in the markets every day…………………………….The second group of traders are directional traders who enter the market when they perceive that we are trading away from what they deem as value. They may fade highs and lows, identifying value as somewhere between, or they may trade breakouts, placing value away from recent trading ranges. They generally enter the market on longer-term bases than the locals (scalpers)…”

• Understanding Volume by SFO Magazine

“One of the basic rules of thumb for traditional volume analysis is that a healthy uptrend would see expanding volume on up days and contracting volume on down days. Just the opposite would be true for a downtrend. “When you get an exception to that, it can be a sign that trend is changing,”

• Big volume without further upside equals distribution;
• Big volume without further downside equals accumulation;
• Volume tends to peak at turning points;
• Volume often precedes price movement;
• Volume is a relative study.

Shannon outlines an example for a stock that is rallying. “You’d like to see that stock advancing on increasing volume each day, say 600,000 the first day, a million the second day and a million-five the third day. Price pullbacks should see successively lower volume, such as 900,000, 600,000 then 450,000″ to reflect a healthy advance.

One of the old market adages says that once a trend is established, it is more likely to continue than to reverse. “That is even more likely to be true if pullbacks are on declining volume,” says Shannon. For traders who may have missed an entry opportunity on a breakout, if a stock posts a retreat on declining volume, that may offer a second entry opportunity for a trend move.