Trading on Earnings Surprises? Don't Bet on It

NEW YORK (TheStreet) -- In their new book, Clash of the Financial Pundits, Josh Brown and Jeff Macke unravel some of the contradictions inherent in the practice of financial punditry. One of their interview subjects, investor and CNBC commentator Karen Finerman, engages the topic incisively, asking not just rhetorically whether punditry should entertain or "help people."

Delving into the world of financial media, it doesn't take much imagination for me to see the historical link between sports news coverage and televised financial debates. The testosterone-fueled, hyper-energetic pace of panel discussions on CNBC and Fox Business owes its inspiration to the high-energy, pre-game "shout fests" on ESPN.

Despite a mountain of academic and practical evidence that discredits trading strategies based solely on quarterly profit surprises, financial television networks continue to preview corporate results by asking pundits whether investors should buy particular stocks before their earnings are reported. The underlying premise of these on-air discussions is that stocks will rally on news of positive earnings surprises, just as assuredly as sports fans will cheer when their favorite teams win.

Market experts might advise investors to buy a stock ahead of quarterly earnings. That presents two risks. Viewers must first believe that the pundits whose advice they heed have the ability to forecast company earnings with greater precision than the consensus of Wall Street analysts. (After all, if a company were to report an "in-line" quarter, that would hardly be deemed newsworthy or be expected to move a company's stock.)

Wall Street analysts' earnings forecasts often prove inaccurate. The crowd-sourcing website Estimize, which draws profit estimates from a wide range of professional and non-professional investors, claims to produce earnings projections that are more accurate than the "sell side" consensus about 70% of the time.

Given that fact, are you inclined to trust the predictive powers of a single guest on CNBC more than the prevailing wisdom on Wall Street, or the "wisdom of the crowd" on Estimize?

Professional investors might sometimes choose to trade based on the expected outcome of a quarter, but it's probably not prudent for most individual investors to take a flyer in this way.

The "buy ahead of the quarter?" question implicitly assumes that stocks will rally in the wake of positive earnings surprises, and retreat on news of earnings disappointments. However, the underlying reality, based on both academic evidence and practical experience, is far more muddled.

Academic studies should give investors pause before they decide to act reflexively in anticipation of, or in the immediate wake of, an earnings surprise or disappointment. One such study, co-authored by a professor at Villanova University, concludes that "determining the earnings surprise subset" from a group of stocks "does not add value."

Another academic study from the University of Michigan concludes that growth stocks, which appear to react more dramatically to negative earnings surprises than value stocks, owe their inferior performance to "earnings-related news" that is disseminated during the month leading up to quarterly announcement dates. These professors conclude that "little of the return differential" between growth and value stocks is "observed at the formal earnings announcement date."

Having spent 20 years forecasting company earnings for a living, I can understand the tendency to fixate on favorable and negative earnings surprises as though they were "winning" or "losing" scores in an athletic competition. However, the underlying reality is more complex.

A positive earnings surprise might push a stock higher -- if the earnings announcement contains information that changes the market's expectations about the company's long-term profit growth rate or returns on capital, or if its alters the market's perception of the relative risks associated with the company's future earnings performance.

This notion -- that the stock price impact of earnings surprises is uncertain -- is more nuanced than the near-certain reaction of viewers to the outcome of sporting events, the winners and losers of which can easily be identified by their final "scores."

For stocks, parsing between winners and losers is a more complex undertaking. Of course, as Josh Brown, Jeff Macke, and their colleagues accurately observe, nuance and complexity make for bad financial television.

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At the time of publication, the author held no positions in any of the stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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