Earnings Gaps

From Cabot Market Letter 4/22/09

Here are our general guidelines on earnings gaps: 

First, you want to see a stock gap up significantly on earnings—usually 10% or more, and hopefully much more; a mild 5% or so doesn’t cut it. 
 
Second, you want volume to be extremely heavy. That’s usually the case, but as with the size of the gap, the bigger the volume, the better.

Third, and a bit trickier to get a handle on, you want to keep in mind where the stock is within its overall upmove. These days, that shouldn’t be much of a problem—most stocks are just a few weeks off their lows!  But if a stock has been advancing strongly for a few months, possibly enjoying a bullish earnings gap (or two) during that time, any further gap up can often mark a top, even if it’s just a temporary one.

Fourth, you should give extra credence to a big, liquid stock that sports great growth numbers that gaps strongly on earnings. These stocks are often irresistible to institutions who pile in for weeks after an unusually bullish report.

Looking at a couple of examples, Crocs (CROX) gapped up 20% on its first-quarter report in April 2007; volume was 450% above average! Better yet, the stock broke out of a base, which is a particularly strong situation. CROX traveled from 70 the day of the gap to 150 (split-adjusted) at its peak in October.

Apple’s (AAPL) amazing run began soon after we bought the stock in the fall of 2004. You can see here the stock’s big gap up following its earnings report in October of that year, moving nearly straight up to 70 through the end of the year.

There are dozens of other examples (both good and bad … we’ve experienced both), but the point is that a fundamentally strong company that gaps up huge on its earnings is often a great candidate to be purchased right then. So while earnings season provides plenty of risk (that any current holding can gap down), it provides even more opportunity, both from stocks you own gapping up, and from new leadership that you can buy.  

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