Apprenticed Investor: Surviving Silly Season

Examining why strong results from IBM, Apple, Intel and Yahoo! were greeted so differently.
Publish date:

Monday down. Tuesday up. Wednesday up, then down, then back up again -- big. Thursday, down over 0.5% for each of the major averages at midday.

Welcome to earnings season.

It may seem there is no rhyme or reason to how individual stocks respond to earnings reports. If you have been frustrated trying to make sense of it, you are in good company. Many traders have found gaming quarterly announcements to be a futile exercise. My own personal approach is that without some sort of an edge, I'd rather simply

not play.

There are two keys to tracking earnings reports and the way a stock will trade afterward. The first is the expectations for the company's quarter. Not your expectations, rather the collective anticipation of analysts and fund managers for what the company will report and say during its conference call.

But playing the expectation game is only the first step. Once you determine how high the bar is set, you must then consider the stock's recent action. Some results are anticipated well in advance of the conference call. A quick look at a chart is often instructive.

We won't bother discussing a company like



, whose business has been eroding for a long time. The company simply missed its numbers. I'd rather look into why


(C) - Get Report

disappointed. There are two explanations worth exploring; depending on which one you prefer, one makes these stocks a hold, the other a sell.

Some have blamed Citigroup's disappointment on the

General Motors

(GM) - Get Report

blowup. If you believe that's the case, then Citi's problems are probably behind it, and you can hold it until October's report.

I suspect the explanation may be even simpler. Money-center banks like Citigroup have been the beneficiary of free profits, courtesy of the

Federal Reserve

, for the past few years. Why? The carry trade.

Ever since the Fed slashed rates to half-century lows, fixed-income players were able to borrow short (1%) and lend long. That was quite the gift from the Fed to the big banking and bond-trading firms. Not only were big houses making money on proprietary trading for themselves, but clients were doing the same -- generating significant commissions.

With the yield curve now nearly flat, the carry trade is pretty much done. This may be an example of where the massive government stimulus ended up masking otherwise mediocre performance.

As an agnostic trader, I think that, technically, Citi can be bought at around $44 with a very tight stop, and then again around $42, also with a very tight stop. But longer term -- especially after a (presumably) better third quarter, I am far less enthused about it. I'm not short the stock, but would consider doing so on any move back toward $53 after the third quarter is reported.

Tech Tightrope

Let's look at a few others: Why were


(IBM) - Get Report



(AAPL) - Get Report



(INTC) - Get Report

better-than-expected numbers greeted so differently?

IBM has been a serial disappointer, missing estimates something like five of the past seven quarters. So when the company actually beat Monday evening, very few were expecting it.

The chart below, however, suggests that someone had done their homework. While the stock traded flat from the May lows, it rallied smartly the two weeks before earnings. That suggests some very smart research -- or some very chatty execs (I don't know which).

Big Blue Takes Off
IBM's pre-earnings rally could have been a tip-off to its strong report

Source: Barry Ritholtz



was the polar opposite of IBM -- it is a "regularly beat-by-a-penny" outfit. When its earnings were in line with consensus, the reaction was dramatic. No one likes to pay a 50 P/E for a company that merely meets consensus.

When Good Isn't Good Enough
Yahoo's valuation and pre-release rally left it vulnerable to a selloff

Source: Barry Ritholtz

Rational? No. Understandable? Completely.

Intel's report -- and subsequent stock action -- was similarly understandable. The robust sale of laptops, especially in Asia, has been a bright spot for Intel and the PC makers. But this was widely known. Perhaps Intel's midquarter conference call set investors' expectations too high.

Flying Too High
Intel's midquarter guidance had raised expectations, setting the stock up for a fall

Source: Barry Ritholtz

Next, let's have a look at Apple. The expectations were that iMac sales would slow in anticipation of a transition to Intel chips. There was also plenty of chatter about iPod sales reaching saturation.

All wrong:

Halo Effect in Action
Reports of iPod sales slowing left Apple primed to rally

Source: Barry Ritholtz

Then there's


(HPQ) - Get Report

. The simple answer is that the good news was already baked in.

Consider that H-P's stock already had a nice run on the announcement that Mark Hurd was replacing Carly Fiorina as CEO. The expectation became built in that he would reorganize the firm, cut costs and slash jobs. The stock rallied on his appointment -- but yawned on the actual announcement. The share price reflected the reorganization long before it was officially announced.

Pre-Baked Goodness
H-P's chart shows a classic 'sell the news' reaction to the restructuring

Source: Barry Ritholtz

Coming Up: Microsoft and Google


(MSFT) - Get Report

is another difficult stock for gaming earnings. The company is notoriously conservative in its guidance, actively seeking to lower expectations (the better to handily beat them).

But for the first time in quite a while, Mister Softee has a number of upcoming catalysts: XBox 2 before this Christmas; Longhorn OS should be out in 2006; and SQL Server 2000 and on-demand CRM (the better to compete with

(CRM) - Get Report

) should be out shortly thereafter. And while


(GOOG) - Get Report

has an enormous lead in search, Microsoft's history is that it can slowly grind its way toward a competitive position in just about any space.

One caveat: The prospects of these future products represent the potential upside to Microsoft investors over the next few quarters. However, investors should remember that aside from their monopoly products -- Windows OS and Office -- most of its other product offerings --MSN, XBox, Hotmail, Spaces, etc. -- have not been big profit makers, and are all also-rans in terms of profitability for the world's largest software maker.

Still, the chart looks pretty darned good recently.

Looking Good
Microsoft's earnings come as the stock has recently rallied, making it tough to game

Source: Barry Ritholtz

Google is a particularly challenging stock to game. The company is somewhat coy with Wall Street in that it provides no guidance. It's really just a guess as to whether it beats the whisper number (are there still whispers since Sarbanes-Oxley?).

But the reasons to own Google may not show up in a conference call. It has become, essentially, a brain trust with a legendarily difficult admission exam for new employees. Google is one of the most innovative companies on the planet, rolling out brilliant new product offerings on a regular basis. In many ways, it is the anti-Microsoft, with its best days ahead of it.

Heading into earnings, some shareholders may be tempted to take profits. Instead, I'd suggest shareholders with longer-term perspectives consider selling only part of their positions, or alternatively, hedge their long positions by marrying the stock to a put.

Riding That Train
Google has been unstoppable, but the temptation to book profits is strong

Source: Barry Ritholtz

In Conclusion

Earnings reports often look like binary events -- do companies beat expectations or not? But the reality is more complex than that. The key to owning and trading stocks during quarterly reporting is the recent stock action, and the consensus expectations for the company.

Readers are cautioned, however, that without some insight into the company -- some special edge -- it is a particularly dangerous trading environment. Proceed at your own risk.

Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries, and is a member of the board of directors of, a streaming media software company. At the time of publication, Ritholtz had no position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback;

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