Why is earnings season so important?
The four rounds of earnings each year provide investors with the chance to examine the health of US companies. It also provides opportunities for trading, since it creates volatility in stock prices.
The quarterly cycle of US earnings season is a key feature of the financial calendar. Four times a year, listed US companies are required to update the market on their progress and provide an outlook for the coming quarter.
For equity investors, a company’s performance is a vital means of determining the outlook for the stock price, and for this reason earnings releases usually increased volatility in a company’s stock price. The combination of an earnings report, which can provoke volatility, with earnings call in which chief executive officers (CEOs) and other senior staff provide additional colour, means that stock prices can swing wildly depending on whether the call reinforces or detracts from the actual earnings release.
In the long run, company earnings drive the stock market. In the simplest terms, a company with earnings growth and a strong outlook is more attractive to investors than one where growth is slowing or turning negative and where the outlook for the next few months is poor. A market where earnings are growing is more likely to rise than one where earnings are falling.
A key part of earnings season is the publication of estimates for company earnings by analysts that follow the stock. Analysts read the reports and meet management and, from these, attempt to determine whether trading is going well or badly and work out whether earnings will rise or fall. Further, analysts take into account the broader economic situation, and use this to make an estimate of what earnings for a given firm may be.
Crucially, these estimates can be revised up or down in the weeks before earnings season, and the closer a report gets the more these are likely to be subject to revisions. The ‘expectation management game’ is played by companies, investors and analysts; eg if Apple reports earnings of $4 per share, but had been expected to report $6 per share, then its stock price may fall (even if the $4 still represents strong growth compared to the previous quarter or compared to a year earlier).
By contrast, a company that beats expectations (ie reports earnings of $6 per share when $4 per share had been forecast) will often see its stock price rise quite sharply. Companies therefore look to temper expectations before earnings season, so that forecasts do not become overly optimistic.
Investors who are new to earnings season may either find it odd that a company that meets expectations suffers a fall in its stock or wonder why a firm that slightly beats expectations sees no rally in the stock price. To answer this, it is important to look at what the price has done in the run-up to the earnings release.
If the price has rallied sharply before earnings, investors are expecting a strong report, and thus the good news is already ‘in the price’, or ‘priced in’, ie the stock price has moved to account for good news already. If the report only meets expectations, then some investors may sell the stock, since they have benefited from the rise and do not expect further gains in the short-term.
By contrast, if the stock price has fallen significantly before the earnings report that is expected to be poor, then the stock could rally, as investors that had already sold the stock buy it back to close out their short position. Therefore, it is difficult to predict how the stock price will react to earnings season.
But such volatility before a report can provide an opportunity for those looking to trade the stock after a report has been released. For example, a company with a strong record of earnings growth may suffer a rare quarter of weakness, missing expectations for a variety of reasons. The stock may fall in the wake of the report, but this drop might be a good opportunity for those investors that wanted to buy the stock but were reluctant to ‘chase’ the price after a strong run higher. Such dips in the price often occur when a company ‘merely’ meets expectations and provide the chance benefit from a rare bout of weakness in the stock price. The reverse applies for companies with poor performance; a brief period of improvement often sees the stock rally in the short term, but this rebound often proves short-lived as short sellers look to capitalise on the opportunity.
Earnings season is a key part of the stock market’s year and is closely watched by investors of all types. While it produces increased volatility, it also provides opportunities for investors as well.
This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients.
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