I have been writting and reading extensivelly on the subject of reaction to earnings’ surprises and its effect on stocks’ prices in short-term and long-term perspective. As a prove you might see my view and links in the section “How markets work” and “Trading methods”.
About 2 years ago I got acquantant with the effect of earnings thanks to a trader named Pradeep Bonde. Today I noticed that he has a very good summary on the subject:
When a company has a 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.
IBD also has a good article on earnings today. They remind us about two factors that have to be considered during earnings’ season:
1) Earnings season can provide useful clues about the general market. If there is a shift in sentiment, you will see it in the way how market reacts to earnings reports.
A bear market punishes almost all stocks. Investors are in a bad mood and they are looking for the smallest weakness in an earnings report as an excuse to sell. Bear market is built on negative thinking.
Bull market on the other side is build on positive thinking. Investors are in a good mood and they are literally looking for a reason to lift stocks’ prices. If a company misses estimates, investors will be looking for a glimps of hope: a better than expected guidance or several possitive words from the CEO are often enough to send a stock higher, despite missing expectations. And if the company reports well above the expected and raise guidance, you will see it gapping double digit the next session. Bull market rewards performance and often forgives misses. It always sees the postive angle.
2) Be aware of the risks during earnings season. Holding a stock though an earnings report can lead to pain or gain. I personally preffer to deal with a stock after it reports. In the very rare occasions I am long in front of earnings, my position is very small and I always have an option postion to protect my equity.