Earnings Season: How to Prepare for Price Swings & React Accordingly

Tuesday afternoon’s closing bell on Wall Street didn’t just signal the end of the trading day. 

It also rang in the start of first-quarter earnings season. 

Alcoa (NYSE: AA) had the ominous and unenviable task of being the first of the Dow Industrials to step up to the plate. And like a tubby first baseman who’s spent the winter off-season shoveling down junk food, Alcoa swung and missed. Badly. 

Already waddling around with debts of more than $10.5 billion, America’s largest aluminum producer reported further loss of half a billion dollars for the quarter (59 cents per share), as sales plunged by 41%. As a sign of how hard the recession has bitten the company, it compared to net income of $303 million (37 cents per share) in Q1 2008. It was the company’s first consecutive quarterly losses since March 1994. 

The news wasn’t a surprise. As the recession squashes aluminum demand, prices have plummeted around 50% over the past year. At current levels, 70% of the aluminum industry is unprofitable, according to Svein Richard Brandtzaeg, CEO of Europe’s second-largest aluminum producer, Norsk Hydro. 

And with Alcoa projecting a further 7% drop this year, it’s already laid off 13,500 workers and slashed production by 20% since mid 2008. Just last week, it announced that it will shut down half its out output (120,000 tons worth) at a factory in New York. 

So is Alcoa’s news a sign of things to come this earnings season? 

The Current Earnings Season In Context 

Let’s set this earnings season in context… 

It comes amid a sudden, surprising shift in investor sentiment. Out with the fear and panic that gripped the stock market during its winter of discontent. In with a frenetic four-week bout of buying to relieve oversold conditions. Here’s why… 

• The Federal Reserve pumped $1.1 trillion into the credit markets.
• The G20 nations agreed a $1 trillion deal last week and a tripling of lending by the International Monetary Fund to emerging nations.
• The Financial Accounting Standards Board changed mark-to-market accounting rules, which should limit bank losses and boost lending. 

Or perhaps Wall Street just has a case of Seasonal Affective Disorder as spring got underway. 

Either way, when stocks are oversold, it doesn’t take much good news to trigger a rally. But here’s why you should keep that champagne on ice… 

• The rally that has catapulted stocks 25% higher is dangerous, as it comes amid a bear market – often known for producing sharp, surprising rallies that can fool investors. Remember, this rally lifted stocks from 12-year lows and estimates suggest the economy shrank by 4.5% during the last quarter. 

And against that backdrop, we’ve got a short-term downward catalyst in the mix… 

Earnings season. 

Watch For The Earnings Season Domino Effect 

As we’ve seen so often over the past few months, investors have very little tolerance for bad news. 

So brace yourself for an earnings season that will see S&P 500 companies’ profits slide 37%, according to Thomson Reuters. That would mark the seventh straight quarterly decline. 

And if you’re looking to play sector trends, keep in mind that Alcoa’s dismal report could trigger a domino effect of poor earnings in industries that use heavy amounts of aluminum. For example, construction, manufacturing, and transportation industries like autos and aviation.

2 Tips To Combat Earnings Season 

Here are a couple of other earnings season tips… 

Earnings season is a notoriously difficult time to trade. Volatile price swings higher or lower are much more prevalent as companies release their quarterly reports and the market reacts to the news en masse. 

And with the economy in recession, there’s a higher chance of bad macroeconomic data (poor unemployment news, for example) adding to the danger. Whether they occur post-market or pre-market, because these price swings are tough to predict, it’s essential that you’re prepared in advance, as it’s too late once the action is in progress. 

Here are a couple of steps you can take to mitigate the risk… 

• Position Size: Ensure that your portfolio is position-sized prudently. Don’t invest too much in one or two positions. Ideally, you should invest a similar dollar amount in each position and put no more than 1% or 2% into each position.
• Use Stop-Losses: You should be doing this anyway, but it’s particularly important during earnings season, as they protect you from a shock. 

No matter which way your stocks move after earnings are released, the move will either be for valid, specific reasons, or a market overreaction (imagine that!) Make sure you know and understand them. 

For example, a huge corporate loss, drug failure, or SEC investigation will hammer a stock. But even when the news is good – such as a big profit, takeover announcement, or strong future guidance – a stock can decline as investors take profits. 

Earnings reports are usually short-term catalyst events. But it’s a time when the “herd mentality” can rule – especially when investors are more nervous than usual. Stocks can get rewarded or punished unfairly, so be prepared for price swings and react accordingly, whether that’s cutting your losses or locking in gains.

Martin Denholm
Smart Profits Report