Protecting Yourself Ahead of a Bumpy Earnings Season

Tomorrow officially kicks off the September quarter’s earnings season. As you know, earnings season, the time in which public companies report their revenue and earnings performance for the prior three months, can be exciting if companies meet or beat Wall Street expectations. The excitement can build if a company beats those expectations and raises its guidance for what lies ahead. The mirror image of that, however, can be rather painful to watch and also to your holdings.

It used to be when a company missed quarterly expectations, particularly for its expected earnings per share figure (or as the Wall Street lingo goes “the bottom line”), its shares would get hit. The larger the miss, the deeper the hit to the share price. Intuitively, this makes some sense. After all, earnings are a key gauge by which we value stocks. If we need to reassess the company’s earnings power, then maybe the shares aren’t worth as much as we previously thought.

Again, that seems to be fairly logical.

What if I told you that companies were seeing their shares drop 10% or more when they simply miss bottom-line expectations by $0.01 per share in earnings?

All of a sudden that share drop may look like it’s a bit overdone. If that’s the case, perhaps that pullback represents an opportunity. Then again, perhaps not.

How do you tell which one it is?

It goes without saying that in order for me to get interested in a particular company, its business needs to be benefiting from one of my PowerTrends. If it’s not, then I just keep moving past.

If the company is a beneficiary of a PowerTrend and everything on my due diligence list (you did read my 10 Questions series, right?) checks out, it means the company’s shares are probably on my contender list. If they’ve made that cut, then I’m looking for the net upside in the shares to reach the right level of at least 20%. As a quick reminder, net upside means the potential upside less the potential downside. While it would be great to think a stock can only go higher once we buy it, as almost anyone who has ever bought a share of stock could tell you, that view is rather naive.

So, let’s go back to the question at hand, how to determine if an earnings shortfall is a buying opportunity or not. Assuming the reasons why you originally bought the shares are still intact, and the earnings miss is not substantial, then it very well could be. If, on the other hand, your weekly reading and data point hunting has turned up some things that indicate deteriorating fundamentals or new competitive pressures, and the earnings miss or guidance cut is meaningful, it’s probably best to steer clear. There are simply too many stocks out there to waste your time on the ones where the outlook is heading south. Again, as virtually anyone who has bought shares of stock can tell you — no matter how hard you wish it, mentally willing a stock to move higher rarely, if ever, works.

Now you’re probably wondering, “Why bring this up?”

As I shared with Melanie Morgan on KSRO Radio earlier this week, I have my concerns about the upcoming earnings season. Last Friday’s weak-across-the-board September Employment Report simply caps off the growing list of weak economic indicators that we’ve been getting. While I tend to disagree with the International Monetary Fund’s (IMF) forecasts — they tend to be too rosy in my view — I have to say IMF Chief Christine Lagarde summed it up well last week when she said, “On the economic front, there is… reason to be concerned. The prospect of rising interest rates in the United States and China’s slowdown are contributing to uncertainty and higher market volatility…”

We’ve started to get a number of negative earnings pre-announcements — FedEx (FDX), Caterpillar (CAT), Taiwan Semiconductor (TSM), Swift Transportation (SWFT) and more — as well as more companies announcing job cuts and missing earnings expectations. Recently, ConAgra (CAG) announced it would lay off 1,500 folks, and Bank of America (BAC) is trimming staff as well. Even Dunkin’ Brands (DNKN) announced growth would be slower than expected and that it would be shutting 100 locations over the next few quarters. Faced with slowing demand and the prospects of higher minimum wages as we enter 2016, I would not be surprised to hear of more companies making headcount cuts. Certainly, such reductions are not good news for our economy. Even though the September quarter’s earnings season doesn’t start until tomorrow, we’ve already seen big misses from Adobe Systems (ADBE), Yum! Brands (YUM) and Nu Skin (NUS). Odds are these are just the beginning of third-quarter earnings shortfalls.

So yes, I do expect the next few weeks to be rough for the overall stock market. That’s why in my options trading service, PowerOptions Trader, I recommended that subscribers add what I call protection to their portfolios in the form of calls on an inverse-market exchange-traded fund (ETF). Should the market decline, the inverse ETF will move in the opposite direction and likely generate a profitable position. Because of the leverage associated with options, a more pronounced move relative to the underlying position, in this case the inverse ETF, tends to occur.

With that recommendation in place, I’m building my shopping list so my subscribers and I are prepared to capitalize on what’s to come and to position ourselves appropriately later in 2015 and into 2016. Hopefully, a few companies on my contender list will modestly miss earnings and give us a chance to get on board at a better price.

In case you missed it, I encourage you to read my e-letter column from last week about how to protect yourself in the midst of a slow economy. I also invite you to comment in the space provided below my commentary.