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Options Can Brighten Earnings Surprises

For the past few months, it seems like macroeconomic forces such as terror, inflation and interest rates have dominated investment decisions. Hopefully, now that Wednesday's Federal Open Market Committee meeting has settled the interest rate question for at least the next six weeks, investors can focus on upcoming second-quarter earnings reports.

Unlike trying to handicap what the Fed might do and then divine its impact on the stock market, earnings provide a more immediate influence. And they're ultimately the most important criteria in determining a stock's value.

While there is no way to know for certain how a company's stock will react following its earnings release, there is often a sell-the-news reaction. But according to research by Keith Miller, a quantitative analyst at Smith Barney, there are also discernable price performance patterns prior to the reporting date.

Specifically, he concludes that "the rewards from accurately forecasting earnings surprises are much greater in the two- to five-week period before the earnings report than they are in the weeks after." Miller's study shows that the top quintile of stocks in the Russell 2000 with the largest earnings surprises outperform the broad index by some 4 percentage points in the four weeks before they report.

Getting Surprised

The key, of course, to capitalizing on this price run-up ahead of earnings lies in the phrase "accurately forecasting earnings surprises." Thankfully, Miller has provided a glimpse into his (and Smith Barney's) quantitative methodology for finding candidates. His recent report describes the calculation for standardized unexpected earnings, or SUE, as the difference between the company's actual reported earnings and the mean of analysts' estimated earnings, divided by the standard deviation of the estimates. The higher a stock's SUE, the greater the expected surprise. This historic or realized SUE is based on the most recent 16 quarterly earnings reports.

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