Earnings – Hot, Cold or Just Right?

With the earnings season 15% done one major question looms for investors… Will lower earnings be a trigger for a correction? That is a great question, but unfortunately one that cannot realistically be answered looking forward. It will be clearly answered looking back after all the earnings are reported. Of course that doesn’t help you and I make the most of our money going forward. As you know, I am not much on attempting to be a prophet when it comes to investing or much else for that matter, but especially investing. We can all make educated guesses based on what we know and want to believe will be true about the future. The challenge comes in the belief strategy we deploy and the flexibility we have to change course or direction in the event our beliefs are wrong or slightly off course in timing. As the old saying goes, ‘a broken clock is still right twice a day’. A willingness to make the necessary adjustments or to admit we were completely wrong is where true investing strategies really begin.

Using earnings as  current example of how to manage our beliefs going forward is good way to put this belief strategy into practice. Prior to the current earnings period beginning the projections were for approximately a 7% growth rate to earnings quarter-over-quarter. That was disappointing as it is well below the double-digit growth the market had been producing. Thus, the belief is/was that earnings would disappoint investors and lead to a possible correction or trend shift short term in the broad markets. This is where the strategy/belief becomes a reality or completely wrong. How do we manage our portfolio based on the belief earnings will disappoint and cause a trend shift or correction? Sell everything and get short the weakest sector? That would be one strategy or approach, but over the first three weeks of earnings that would have been a very costly move. The major indexes have continued higher and there has been no real signs of selling. Thus, it is safe to assume that making radical changes based on your belief is not generally the best course of action.

Over the last thirty plus years I have learned it is important to have a belief window, but equally important, is to be patient and let your belief either be validated by the markets action going forward or invalidated by the markets. A simple application of Boolean logic would be appropriate. This is the old cause and effect we use in performing science experiments… if this happens, then this results. Applying that to this example, if earnings do disappoint my stops are at X and I will be out of that position which is the action I would want if my belief was true. However, your belief can be right and the market not react as you would expect. Thus, if earnings disappoint and my stops are at X and the market continues higher, I still own my position and continue to make money despite my belief being right and the market acting irrationally. You get the point, validating a belief is equally as important as the belief itself. However, patience is required to see how it plays out going forward.

Do you see what is happening? We are taking the doom-and-gloom belief that we tend to believe more than the everything is coming up roses outlook, and applying logic to manage our portfolio. The need for absolutes in our analysis and management of money becomes a stumbling block to making good investment decisions. Here is where the art of managing money meets reality. The best offense sometimes is a good defense, to borrow a sports analogy. I was driving may car home from the office observing all that is around me and just enjoying my drive home at 45 mph  with others flying past me at 60 mph and others beside going at the same speed. Needing to make a left turn, I got in the left turn lane and waited for the signal to turn green so I could proceed towards my destination. The light change I accelerated through the intersection and much to my surprise I was hit by an oncoming vehicle at 35 mph into the drivers side of my car. Needless to say the shock and impact was much different than what I believed would happened when proceeding through the intersection. The driver of the other vehicle promptly got out and accused me of cutting in front of him and … well you know how the rest of the story went. Thankfully the car behind me had stopped to help and gave witness to the fact that the other vehicle had run the red light and was in the wrong causing the accident.

What did I learn from this event? That even though you believe something to be true, it doesn’t always work out that way. I was convinced that it was safe to proceed through the intersection and proceed towards my destination. However, an event took place that derailed that belief. That is why a seat belt, an airbag and insurance were used to protect me against something going against my belief. Investing is no different, you have to plan for what you believe, but have protection in the event you are wrong. Or, worse yet you were right, but the market didn’t care and it did the exact opposite of what it should have done relative to the event. Planning is the best tool you have when it comes to investing. At first, it is time consuming and work, but as you practice and develop the habits that work for you, it becomes second nature. Good investors/traders always have a plan of action based on their beliefs. Without it we are subject to what the market does, good or bad.

If we go back to our original question relative to earnings impacting market direction going forward, my belief was and is, yes they will impact the directional pivot of the market short term. The expectation is on the downside and remains on the downside. We have had just enough good news in earnings to offset the bad at this point. Case and point NetFlix surprising analyst and the stock  goes up nearly 20% on the news. That good feeling relative to one company can and does carry over to the broad markets for the day or two, but it still comes down to the body of work (earnings) overall that will determine the outcome going forward. With that in mind, I have reviewed each position that I own and set my stops accordingly. If market moves lower I will be out of those positions. If the market continues higher, we will maintain my positions and trail my stops higher to protect the position with the future taking care of itself. The market is still in the process of determining if earnings are hot, cold or just right… and I am working to manage my expectations relative to my portfolio and the stops in place to manage my risk. Right or wrong our beliefs will be validated or proven wrong over time. What is important is managing the risk of the markets relative to my beliefs.