Navigating the Earnings Quarter: Unveiling Market Dynamics One Quarter at a Time
In 1979, legendary rock band The Clash added a surprise track to their "London Calling" album at the last minute. Many argue it's their best song, yet, it steered clear of the expected title that resonated with its repeated phrase, "stand by me". Instead, it was named "Train in Vain", a phrase not even audibly present in the lyrics, sidestepping any confusion with Ben E. King's famous track.
Drawing a parallel to this musical anecdote, we delve into what is commonly known as the earnings cycle. Yet, to sidestep confusion with Richard Bernstein's 'Earnings Expectation Life Cycle', we christen this phenomenon the "Earnings Quarter". This article offers a lens to view the fluctuations in price from the end of one quarter to the earnings announcement of the next.
Publicly traded companies typically unveil their performance results quarterly, modifying the narrative slightly with each reveal. This alteration in the storyline paves the path for either outperformance or underperformance compared to the broader stock market. This cycle commences as companies close their books at the end of every calendar quarter. After a meticulous review by internal accountants and external auditors, the newly collated data is released to the public, acting as a catalyst that shapes the stock's journey.
Analyzing the stock price behavior and earnings releases of companies priced over $5, with an average daily volume exceeding 150,000 throughout the quarter, uncovers intriguing patterns. In the last quarter-century, 53% of stocks experienced a surge post their earnings announcement, averaging a 3.5% gap, while the remaining faced a dip, averaging a 3.8% gap. However, these initial gaps offer little insight into the stock's trajectory as the quarter unfolds.
The real determiner of the post-gap direction is sentiment, particularly the alignment between results and prevailing sentiments. A unanimous expectation of strong results might fuel an initial rise in stock, but sustaining this ascent becomes challenging due to potential sell-offs.
In this context, we spotlight an "outperformance scenario", where stocks more likely shoot up post earnings declarations. A phenomenon termed as Post Earnings Announcement Drift (PEAD), identified by Ray Ball and Philip Brown back in 1968, becomes a focal point here. PEAD manifests in two forms: a short-term drift spanning the initial five days post earnings release, and a longer-term drift that persists until the next earnings announcement interrupts the narrative.
Our Power Rating system serves as a tool to discern when market expectations diverge drastically from company statements, indicating potential overreactions and quick shifts in position. On the other hand, our Earnings Whisper Grade evaluates the prospects of a longer-term drift, giving greater weightage to earnings quality compared to the Power Rating.
This analysis isn't just a tactical play for the market-savvy. Even less seasoned traders can capitalize on the Post-Earnings Announcement Drift, especially when aligning their strategies with strong Earnings Whisper Grades. The key here is to sidestep the immediate volatility post-announcement and to consider holding positions until the commencement of the next quarter's announcements.
However, this isn't just a game of numbers. It acknowledges that companies exceeding earnings expectations are more likely to outdo the market averages. Yet, it's crucial to consider the influence of macroeconomic conditions, industry trends, and market movements during the post-announcement phase.
As the quarter nears its close, a discernible shift occurs, often referred to as the 'Run-up' phase. During this period, analyst checks commence and new reports circulate, igniting a shift in investor sentiment. This phase sees an overlap with the longer-term PEAD, a phenomenon corroborated by Bernard and Thomas in their 1989 paper.
In the ensuing weeks, data accumulates, aiding in the computation of the Earnings Whisper Number, while option prices witness a surge in volatility. Echoing this concept, William Beaver introduced the 'Earnings Announcement Premium' in the Journal of Accounting Research, highlighting the significant price movements surrounding earnings announcements. Interestingly, there seems to be a favorable statistical edge to purchasing stocks about a week before positive earnings releases, with benefits extending to holding through until post-announcement fluctuations stabilize.
As we navigate through the Earnings Season, a time when companies report results almost concurrently, certain stocks mirror the positive performance of their counterparts, further enhancing their potential for outperformance. And despite the inherent unpredictability, these anticipations often prove to be correct, granting an advantage to those who hold positions until the post-announcement calm.
Yet, as this cycle repeats, the narrative morphs once again, molded by evolving sentiments and the intrinsic quality of the earnings, charting a fresh course in the intricate journey of stock market investments.
