March 26, 2019

The Importance of Earnings and Earnings Season

Consistent earnings are arguably the most important driver of individual stock performance over the long run—and by extension, the overall stock market.

If the majority of companies, particularly the established market leaders, are growing their sales and earnings, traders tend to feel more confident about future market prospects. On the other side of the coin, 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: (1) earnings surprises, (2) bellwether performance and (3) overall results vs overall expectations. 

When is earning season?
The phrase "earnings season" refers to a period of several weeks after each quarter-end (i.e., January-February, April-May, July-August, and October-November), during which many U.S. corporations report their quarterly sales and earnings.

What should traders watch?
There are three important aspects to earnings that traders should look for during earnings season:

1. Earnings surprises
An earnings "surprise" is when results are significantly better or worse than analysts had expected. Positive or negative earnings surprises can have a profound impact on the performance of an individual stock, and can often propel a given stock on a meaningful uptrend or downtrend.



What Traders Look For What Traders Look Out For
During earnings season, fundamental traders may pay attention to whether the majority of earnings surprises are positive or negative. If the vast majority of earnings surprises are positive, it is generally considered to be a sign that "business is good", and is a bullish sign for the stock market overall. A negative earnings surprise for a given company can devastate the price of that company's stock and potentially launch a downtrend that can last for just a few days or an extended period of time. When a host of companies experience this type of negative event within a few short weeks, it can spook the investing public, which can cause them to scale back their stock buying. This reduction in buying demand can weaken the stock market in the interim.


2. Bellwether performance
Some companies and industries are thought of as "bellwethers" or indicators of the health of the stock market and overall business activity. Throughout much of the 20th century, General Motors and IBM were typically viewed as market bellwethers. If one of these companies stumbled it was typically viewed as a troubling sign for the overall economy. In more recent years, companies like Microsoft and Apple have also served in this role, and other companies will inevitably follow suit.

What Traders Look For What Traders Look Out For
The bottom line is that if companies that are thought of as leaders are performing well, it can be considered to be a good sign for the stock market—and by extension, the overall economy—and vice versa.

Anytime that bellwether stocks' earnings surprises or overall results come in below expectations, it can serve as a warning to traders that trouble may be ahead for the stock market, and potentially for the overall economy.

3. Overall results vs. overall expectations
Many analysts at many financial firms 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 many built in expectations among the investing public as to how well earnings should look overall based on these various estimates.

graphic on expectation vs reality
What Traders Look For What Traders Look Out For
If the actual overall earnings results being reported are generally in-line with optimistic expectations or exceed expectations, this can be a sign of an improving environment for the stock market and business overall. When overall earnings are perceived as "disappointing" during a given earnings season, it can have a chilling effect on investors over the course of the next quarter or longer.

Perception is reality
Earnings and sales growth can be fundamental drivers of traders' perceptions and stock prices in general. Many traders plan and prepare for earnings seasons by knowing what is expected of the stocks they're tracking. Additionally, while fundamentals are important, the emotional component of investing should not be overlooked; meaning investors' perception of market (or individual company) strength can often be as important as the actual strength of the market (or individual company). If it's perceived that a company will deliver certain results, but either falls short or exceeds them, a stock can be severely punished or handsomely rewarded. This is why results versus expectations typically have more impact than actual profits or losses.