Happy earnings season, traders!
Consistent earnings are arguably the most important driver of individual stock performance—and by extension, the performance of the overall stock market—over the long run.
If most companies, particularly the established market leaders, report increasing sales and earnings, traders tend to feel more confident about the market’s prospects. When earnings are trending below expectations, it can be a warning sign of potential trouble ahead.
Here, we look at the three things that traders should track during earnings season: whether companies' reported results are broadly in line with expectations across the market, how bellwether companies are performing, and individual earnings surprises.
Performance relative to expectations
Analysts spend a lot of time estimating how well a given company or industry is likely to perform in terms of generating earnings and sales. As a result, when earnings season begins, there are already built-in expectations among the investing public about how earnings should look overall.
If the results companies report are generally in line with analysts' positive expectations or exceed them, this can be a sign of an improving environment for the stock market and business overall.
When disappointing reports start to pile up, it can have a chilling effect on investors over the course of the next quarter or longer.
This may all seem obvious enough, but it's worth noting that there are both fundamental and psychological reasons for these dynamics. On one hand, earnings and sales growth on their own can be fundamental drivers of stock prices. On the other, perceptions of strength relative to expectations also matter, so that traders might punish a company that reports growing earnings that nevertheless fall short, or reward one that loses less money than they’d feared.
Certain companies and industries are thought of as "bellwethers," meaning they are considered broadly representative of the health of the stock market and overall business activity. Classic examples from the last century include General Motors and IBM, though today analysts are more likely to look at companies like Microsoft or Apple.
If a bellwether is doing well, the thinking goes, so is the market, and vice versa. Think of it as another perspective on the market.
Individual earnings surprises
Many traders plan and prepare for earnings seasons by knowing what is expected of the stocks they're tracking. As noted, surprises, whether positive or negative, can have a profound impact on the performance of individual stocks—potentially enough to push them into a new rising or falling trend.
Be aware that companies can report results when markets aren't even open, which can cause their stocks to "gap," or make a sharp move up or down with no trading occurring in between. One way to protect yourself against a precipitous slide in the event of negative surprise is to set up a stop-limit order, which is an order to sell a security at a specified limit price once the security has traded at or through a specified stop price. If a stock trades at or below the stop price, the order will trigger and become a limit order to sell at the price you've specified. However, your order won't be executed unless a buyer is willing to pay the limit price you've specified (or better). If no buyers will pay your price, your order won’t be executed.
Stocks that "gap up," on the other hand, may present a great selling opportunity. To prepare for these situations, some traders consider using a trailing stop that trails the bid price of the stock as it moves higher. The stop price essentially self-adjusts and remains below the market price by the number of points or the percentage that you specify, as long as the stock is moving higher. Once the stock begins to move lower, the stop price freezes at the highest level it reaches. In other words, the stop price can move higher indefinitely, but it can never move lower.