• How to trade during the earnings season?

    As I have been repeatedly writing about it in the daily comments, the current bounce is entirely due to lower rates that pushe liquidity into ETFs and the largest stocks.

    1. Index investors

    We can see below that the QQQ/SPY have displayed almost straight lines accumulation patterns.





    2. Pair Trading

    Large caps have generally outperformed



    and have constantly attracted more money than the small caps. This is partly also due to pair trade activities: funds buy the largest caps while shorting the small caps to try to keep a balanced portfolio.

    S&P500 stocks display a strong Money Flow, especially the largest stocks,



    such as the NQ8 stocks.



    All of this points to pockets of malinvestments. That is stocks that have been pushed up with the rest of the market, but that might fall hard if they announce negative guidance or a slowdown in sales.

    3. The Money Flow

    However, on a general money flow basis, we can see below that there is no reason to short the markets: large investors do continue buying.



    4. The macro view:

    On a macro view, we can see below that the earnings yields (Green line) are still well above the corporate high quality bonds yields (Pink line)



    It is when these two lines meet that markets correct, because money leaves equities to buy HQ corporate bonds. As a consequence, earnings yields increase. See the Blue arrows from October 2018. In 2019, the Fed stated to be reversing its position in rates. US 10Y rates then pulled back, pulling also the corporate bonds down. This helped equities prices, simply because the difference between earnings yields and corporate yields stayed high.



    Today, the S&P500 displays a general EPS of 135.39$. This is how the current earnings yield of 4.46% is calculated. For the earnings yield to reach the Corporate HQ yield, earnings would have to fall to 102.5$. This will not happen, at least not in one quarter. We would need a general recession, but the Fed would certainly lower rates down to 1%, which would stabilize the markets.

    On the other hand, if earnings stay stable this quarter, the S&P500 has room to climb to $4000 before the Green and the Pink lines meet again. This means that by lowering rates in the current market environment, the Fed fuels assets inflation.



    Conclusions:

    There is no room to shorting the markets here, unless there is a general earnings miss and extremely negative guidance. I do not believe that this will occur. It is most probable that a general pullback will not happen before 2020 and maybe fear related to the Presidential elections.

    In the meantime, we can trade pockets of mis-investments. I do this by buying puts on companies that display a negative Effective Volume pattern ahead of earnings. I use puts because my loss is kept under control, while my gain can be substantial. If for example I plan to invest 20,000 $ on a single equity position with a 5% stop loss level, I would limit my investment to 1,000$ using puts. The target gain is between 2,000$ and 3,000$. I also use to buy puts that expire in one or two months, in order to avoid the time decay.

    Below are four trade ideas that still need to be confirmed on Monday/Tuesday.

    ADTN for example seems to be in a consolidation mode in terms of price. The past two earnings were rather good.



    The problem is that the EV pattern for now is negative. Of course, I have no insider information and hence I do not know why the selling occurs now, but I am ready to buy puts ahead of earnings of July 17.



    Note below that before the last two earnings, the EV patterns were positive. This tells us that large investors seem to be trading earnings insiders information.





    GPC tells a similar story: the current bounce does not attract buyers.





    Just days before earnings of last April, the EV pattern looked slightly negative.



    Finally, POOL and SXT, which have their earnings next week also look weak in terms of EV patterns.





    PS: I have no position in these stocks. Those who want to try the real-time EV can send me an email, I'll open them a free 10 days trial.
    Comments 1 Comment
    1. Pascal's Avatar
      This is a follow-up on the weekly comment posted last week regarding possible short trades based on the Effective Volume pattern.

      We can see below that SXT and GPC lost 10%, ADTN lost 25% and POOL gained 5%

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      Using puts with an investment that is equivalent to 10% of a normal short position, you can usually gain 300% on the position if the stock price moves 10% and 500% if the stock price moves 20%. This means a substantial gain even when referring to the original price of the stock. The risk being to lose 50% to 100% of your investment.

      In the case of POOL, the price gain was only 2.5%. Hence the put lost 30% to 50% of its value.

      This type of trade is not magic. It is based on the fact that some insiders have knowledge/deep analysis on the coming earnings and hence act before publication.

      In the case of ADTN, earnings were OK, but the company was undergoing a review of its stocks of obsolete products. During the conference call, it was announced that next earnings would be hit by write offs. This had been known by many insiders and hence the large negative EV pattern before earnings.

      This type of trades work best with mid/small sized stocks. It does not work for very large stocks such as AMZN, AAPL, NFLX, etc. because most ETF liquidity moves into these stocks and also because even the small players of the EV pattern include many large funds. Hence, the signal of large players may represent something else than advanced knowledge.

      But even for small stocks, a large fund could be afraid before earnings and lighten its position. So there is always the risk of being wrong. However, statistically, since the Risk/Reward ration is 1/2 at least, if you have a 50% chance of success, this leads to substantial gains only during a brief earnings season.