How to Handle Earnings Season
Two Potential Earnings Winners
One of the reasons I love the stock market (though sometimes it's more of a love-hate relationship) is that it's such a battle of the mind. Of course, few pundits or analysts will tell you that--to them, it's all about number crunching, research, valuation and industry analysis. And all of those are important.
But when you get down to it, with money on the line, buying and selling stocks becomes emotional. We've all experienced the range of emotions--not just fear and greed, but euphoria when your stock gaps up on earnings, depression when it gaps down, etc. Moreover, there's the emotional state of the investor, such as overconfidence (after a good run of profits), or feeling like a moron (after a string of losers).
Really, though, it's how you handle those emotions that will go a long way toward determining how much money you make and keep in the stock market. The investors that shoot from the hip and react to every wiggle in the market generally do poorly. Those that have a well thought out plan are usually the ones that excel.
Today, I want to touch on a topic few like to chat about--how to handle losses. Why? First, because most of us have experienced more than a few losses in recent months, whether it's from a 401(k) plan or from individual stocks, and we feel terrible about it. Second, because no matter who you are, and no matter what the market does, you're going to experience some losses on trades in the months and years ahead, and it's vital to think about losses in the right way.
Believe it or not, my personality is a bit at odds with being an aggressive growth investor. In fact, I often think of myself as a "conservative aggressive" investor--for whatever reason, the pain I feel during drawdowns (drops from a portfolio's peak value) is much more intense than the joy I get from having a good month or two. It's just the way I am.
Thus, even though I cut all losses short so they can't cause enormous damage (rule #1 of growth stock investing!), I tend to take losses seriously ... possibly too seriously. Because I run a relatively concentrated portfolio (up to 12 stocks in Cabot Market Letter's Model Portfolio), each loss takes a larger chunk of the total portfolio than, say, if I had 20 or 25 stocks.
However, while losses are extra painful for me, I try to think of it this way: The stock I just lost money on is one of thousands of trades I'll make in the years ahead. While seeing some money go up the chute stinks, thinking this way helps me remember that I'm not in the stock market to get rich this month or this year.
I also try to remember that, since I'm using a proven system, I'm putting the odds in my favor ... but that doesn't mean the odds will always win out. If I think a trade has a 65% chance of working, that still means I'll lose money 35% of the time. And, realistically, you're probably going to lose money on nearly half your trades, and make money by having your winners outweigh your losers (i.e., your winners will go up an average of, say, 25%, while your losers will fall an average of, say, 10%).
Thus, losses are simply part of the process, and that goes for novices or experienced professionals. The difference is that novices personalize the losses and never learn from them. Professionals realize losses are inevitable in the stock market and learn from them.
I realize this isn't the most joyous topic, but I also know that the past 18 months hasn't been the most joyous of market environments. Thus, if you're still feeling down and out about the past, get in a better mindset--look to learn from your losses, as opposed to being weighed down by them.
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It's that time of year again ... and no, I'm not just talking about tax season. (I could go on a diatribe about taxes and the wedge between work and reward any time ... but not today.) I'm talking about earnings season, which in recent years has become a make-or-break time for many investors.
Personally, I've experienced both sides of the coin. Sometimes I'll be on a relatively hot streak, with my stock holdings acting well, but one or two big gaps down on earnings takes away weeks worth of gains. But I've also seen my portfolio acting like a stick in the mud, only to shoot ahead and produce great profits as a couple of my holdings gap higher.
A couple of years ago, I spent lots of time trying to examine characteristics of stocks that gap up versus gap down on earnings, but I haven't unearthed anything consistent. Said another way, it's all pretty random.
So how should you play earnings season? There is no one, perfect way. But I'll highlight the good and bad of three different, realistic scenarios.
Option 1: Ignore earnings reports, and just buy and sell as you normally do. In the long run, this is likely to produce your best results, as good companies in good market environments will, more often than not, react well to their earnings. However, this method will also produce plenty of swings in your account--big drops will be painful, while big gaps up will be terrific. You have to be mentally prepared to see your account drop a few percent within a week or two (regardless of what the market does) because a stock or two was crushed on earnings.
Option 2: Sell part of every growth stock you own before it reports earnings. Believe it or not, this is a decent half-way measure ... if you're running a concentrated portfolio. For instance, if you have, say, 12% of your account in a stock that's about to report, maybe you trim that down to 6% or 8%. Doing this across the board will lessen your portfolio's swings, and might actually make it easier to weather earnings season as a whole.
Option 3: Sell most or all of the shares of a stock you don't have much profit cushion in. Thus, let's say you own three stocks, one with a 50% profit, one with a 10% profit, and one with 2% loss. In this option, you might hold on to your big winner, because you're playing with the market's money, and you're attempting to build it into a bigger winner. But you also might sell some shares of your 10% winner, because there's not much cushion there (a gap down could eliminate all of your profit), and you might sell all of the shares of your loser, thinking that you don't want to risk losing a bunch of money should things go awry.
Option 4: This one has nothing to do with selling stocks ahead of earnings season--it has to do with buying. Simply put, if a volatile growth stock is going to release results within a week, don't buy it, or don't buy much. The thinking is that you won't have enough profit cushion before the report is released; it's more like gambling than investing.
None of these methods is "correct," as what really counts is getting a method that will keep you from freaking out during earnings season, or make you so uncomfortable that you'll fail to stick to a game plan. Personally, I see nothing wrong with taking some chips off the table ahead of earnings reports, and I usually try to avoid taking a major position right in front of earnings.
But that's just me--as I wrote above, I detest losses, and generally prefer a smoother equity path (fewer ups and downs). I know a few great investors who simply hold on through all earnings reports, never adjust their strategies and do just fine ... albeit with lots of volatility.
So my advice for you is to do some mental homework. Examine your portfolio and pretend that one of your stocks gaps down 20% ... and then compare that feeling (and monetary damage) with the one you'll have if you sell half your shares in a stock the day before it gaps up 20%. Determining which one you can tolerate better will tell you what strategy to pursue during earnings season.
To this point in the market advance, there hasn't been much for me to get excited about. What do I mean? Isn't an S&P rally of 25% from its lows enough to get me excited?!? Yes ... in terms of the general market. But, to be honest, my system thrives on the action of leading stocks--those with great sales and earnings growth, big stories and revolutionary products. And thus far, there haven't been a ton of leaders setting up in high-odds buying patterns.
Why leading stocks? Why not focus on all stocks, junk included? Simply put, because leaders LEAD the market higher on sustainable runs. There has never been a sustainable rally that hasn't featured many powerful leaders heading higher. And leaders are where the biggest winners in history have been found! So, while in the short-run it can be lucrative to play those lower-priced, beaten-down sectors, over time your best profits will come from the leaders.
And some of the best leaders are the big, liquid ones--the stocks that trade millions of shares per day that institutions can pile into. So, today, I want to mention two well-known companies that are reporting earnings before my next Cabot Wealth Advisory. Big gaps up could kick-off new advances.
The first is Amazon.com (AMZN), which, truth be told, isn't sporting the earnings growth these days that I crave. That's mainly because of the recession, but more important to me is the fact that the firm's Kindle, its e-book (and potentially e-everything) reader, could be an absolute game changer in the quarters ahead. The stock has come a long way from its lows of last year, but remains off its 52-week high. AMZN reports earnings next Thursday evening, and a strong gap of more than 10% that puts the stock above 85 or 90, would be tempting.
The next stock is Visa (V), which, remember, is still a young stock (just over one year old). It hasn't risen like Amazon has the past few months, but the stock is attempting to break above multi-month resistance around 60, and the company's growth numbers are steady (and the profit margins are simply insane). Earnings are out on April 29 after the market's close. A big gap up of at least 10% will likely be buyable, assuming the stock is gapping above that key 60 level.
There are many other earnings reports to consider in the weeks ahead, but these are two big, liquid stocks that could turn into institutional favorites following their reports. Watch for them!
All the best,
For Cabot Wealth Advisory
Editor's Note: Cabot Market Letter's three market-timing indicators are all flashing BUY! Editor Michael Cintolo has already purchased four leading stocks for the Model Portfolio and he expects to buy more soon if the market holds up. From the market's bottom in March 2003 to the recent low in March 2009, the S&P 500 lost 18% in total and the Nasdaq lost 3.5%. Cabot Market Letter, however, left them in the dust: Advancing a total of 94% during the past six years (nearly 12% per year). Click here to find out more.