Unlike last quarter, when the statistics regarding the state of the economic recovery were up for debate and the earnings Magic 8-Ball still read "cloudy" at best, we're now seeing some definitive positive data.
The shift is most noticeable in how stocks trade ahead of, and more importantly, after, issuing earnings reports. While last quarter saw distinct sell-the-news action, stocks such as
are each tracking higher following this quarter's results.
While valuation concerns remain and there are still questions about whether this good news is already priced in, the pattern of selling on the news seems to have been broken. Earnings provide a catalyst for price movement and implied volatilities on options are generally low, meaning that the leverage of options can allow you to reap the rewards of playing earnings predictions.
"One of my favorite short-term trades is to sell or short a stock just ahead of its earnings release," said Bill Ginsberg, founder and manager of Alzeon Capital, a New York-based hedge fund that focuses on short-selling. But Ginsberg hasn't been employing that strategy this quarter, saying "the stars are just lined up,
there's too much momentum and too few candidates for a major shortfall." Given Ginsberg's bearish leanings -- his fund is either short or in cash, but rarely long -- his statement is tantamount to being bullish.
Given that we're only halfway through earnings season, with not even half of the
companies having reported thus far, there is still ample opportunity to game and trade ahead of third-quarter earnings releases.
Attempting to remove emotion, bias and even valuation from the equation, I turned to quantitative research performed by Keith Miller of Smith Barney. In his Oct. 10 report, he describes a model to forecast which companies are most likely to deliver "standardized unexpected earnings," or SUE (otherwise known as a surprise), and he supplies some data on how those shares trade during the weeks surrounding the earnings release date.
The short definition of the proprietary computation of SUE is the difference between the company's actual earnings and the mean of analysts' estimated earnings, divided by the standard deviation of the estimates. Other considerations include price momentum, equity capitalization and margin expansion. "Each element is serially correlated in that they tend to repeat in the same direction for at least two consecutive quarters," explained Miller.
Miller has found that using estimates dated six weeks before earnings release dates provides a more effective prediction tool, because they're less influenced by preannouncements that dilute share price response to any subsequent surprises. The research, which Miller has been tracking for over a decade, reveals that this method is most successfully applied to mid- to large-cap stocks, such as those that make up the Russell 1000, and the bulk of the price movement, both positive and negative, occurs in the five weeks surrounding the actual announcement date -- three weeks prior and two weeks after.
While SUE's success rate for highlighting companies that will report better-than-expected earnings has been about 78% over the past five years (about 57% of the Russell 1000 actually beats consensus estimates over the same time period), its value of parlaying that prediction into a profit via the underlying stock price is much harder to quantify. (For SUE has accurately predicted 50% of the companies that posted those interested in the dark side, negative earnings surprises, compared with the fact that just 36% of all Russell 1000 companies have disappointed during that time frame.)
Calling on Calls, Purchasing Puts
Miller's number-crunching for this quarter reveals a list of 40 stocks that he predicts will post positive surprises and 17 companies he thinks will disappoint. Many in the upside-surprise list are already pressing up against 52-week highs, bringing us back to the original dilemma of chasing stocks that might have all of the good news baked into current prices.
Given that implied volatility is generally low, making many options relatively inexpensive, this is a perfect opportunity to make use of the leverage and limited risk provided by the purchase of options. Buying near-the-money front-month options not only reduces the capital outlay of being long (or short) maximum loss to the premium paid for the option (which will be significantly less than buying or shorting the underlying shares), but the position maintains a nearly limitless profit potential.
The table below offers some SUE candidates for both positive and negative earnings surprises:
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to