Some traders like to trade by guessing earnings reports. E.g. they’ll go long a stock if they expect the earnings report to beat analysts’ expectations and they’ll short a stock if they expect the earnings report to miss analysts’ expectations. Playing the earnings game is rarely a good idea. Here’s why your trading strategy should not revolve around guessing earnings reports.
You can’t consistently guess earnings results
To play the earnings game you first must guess if the company will “beat” or “miss” analysts’ expectations.
Earnings results beat analysts’ expectations more often than they miss expectations. This is becoming more and more true in the modern era because companies know how to play the earnings game. These companies help analysts lower their expectations by issuing negative earnings “guidance”, thereby lowering the bar and allowing for an easy beat.
However, companies don’t beat estimates across-the-board even during the strongest of earnings seasons. There’s always at least a quarter of companies that miss expectations, even when the economy is booming.
It’s not possible to consistently guess whether a company’s earnings report will beat or miss expectations. You can reasonably guess e.g. “2/3 of companies will beat expectations this quarter”. But your guess for any individual stock is a 50-50 bet.
You can’t consistently guess a company’s quarter-to-quarter earnings report unless you have insider knowledge (i.e. connections to key executives). Trading on inside information is illegal.
You don’t know if the company will beat earnings AND revenues.
You not only need to guess earnings, but you also need to guess revenues. For example, corporate reports will sometimes beat earnings expectations but miss on revenue expectations. Beats on earnings expectations are more common than beats on revenue expectations. This is because companies have a greater degree of control over their earnings than over their revenues.
For example, companies can cut costs faster than falling revenues to boost their earnings in a mild economic downturn. However, companies can’t do much to boost revenue. Accounting tricks aside, revenue is completely determined by customers. No amount of cost cutting or corporate restructuring will boost revenues unless the company is performing better in the marketplace.
You don’t know how the market will react to an earnings report
Guessing the company’s earnings report is hard enough. You also have to guess how the market will react to an earnings announcement. Stocks don’t always go up on an earnings beat.
- Sometimes the stock will go up on an earnings beat.
- Sometimes the stock will go down on an earnings beat.
- Sometimes the stock will go down on an earnings miss.
- Sometimes the stock will go up on an earnings miss.
You cannot guess the stock’s immediate reaction to an earnings report. You also can’t guess the market’s subsequent reaction to an earnings report. E.g. sometimes a market will initially fall on an earnings miss and then surge a few hours/days later. Sometimes a stock will pop on an earnings beat and then fade those gains over the next few days.
You also don’t know if the market will focus on earnings or revenues. For example,
- Sometimes the stock will go down despite strong earnings because revenue missed analysts’ expectations.
- Sometimes the stock will go up despite weak earnings because revenue beat expectations. This is especially prevalent among fast growing tech companies. Traders and investors in these stocks care more about growing revenues than growing profits.
The stock will often gap up or gap down on an earnings announcement. So you will face an instant loss if your prediction is wrong.