Tuesday, February 22, 2011

1st Quarter Earnings Review: Don't Trust Your Gut

   First quarter earnings season is winding down and as of this evening, all 30 stocks in the Dow have reported earnings for the most recent quarter. Prior to today's large sell-off (largest for the S&P 500 and Nasdaq since Bernanke hinted at QEII) the major markets were all up more than 8% in the first month and half of the year. Much has been made about the strong earnings season, accelerating economic growth and positive tailwinds of fiscal and monetary policy. Based on the rampant bullishness pervasive in the market, it would seem only natural that individual stocks would have reacted positively to their strong earnings reports. Since the market has performed so well, I was curious about individual stock performance and decided to dig for some further information.

   As of Friday's close, 27 of the 30 Dow stocks had reported earnings for their most recent quarter. I decided to look at each stocks individual performance in the first three days after reporting. Calculating the results for one day after reporting earnings, 14 stocks were up and 13 were down. The average move was slightly negative (-0.15%), paced by a more than 7% gain in General Electric (GE) and a 14% loss for Cisco (CSCO). Cumulative returns two days after reporting showed 12 stocks higher and 15 lower, with the average return a bit more negative (-0.36%). Returns worsened again after 3 days of cumulative returns (-0.65%), as only 9 stocks had risen while 18 had dropped. Considering the supposed strength in recent earnings reports, these results were somewhat surprising.

   Knowing how well the entire Dow performed during earnings season, I decided to take the research a step further and calculate the cumulative returns for each stock since three days after reporting earnings. For this metric, the period of time varied significantly, however the results were interesting nonetheless. In the period from three days after reporting earnings until Friday's close, an incredible 25 out of 27 stocks moved higher. The average return was over 3.5%, including significant gains from Bank of America (BAC), Alcoa (AA), Proctor & Gamble (PG) and Boeing (BA), which had each fallen more than 4% in the few days following their earnings reports. There are numerous interpretations of this data but I'll suggest a couple. The market has been expecting good earnings, so actual reports offered a buy the rumor, sell the news opportunity. After a few days, rumors of strong future earnings lifted nearly everyone. A different view might be that individually the earnings stories aren't that great, however expectations for future earnings are substantially positive enough to outweigh recent, backward looking earnings reports. (Interesting note: The remaining three Dow stocks reported earnings today. Home Depot (HD) and Walmart (WMT) both reported during pre-market hours and finished the session lower. Hewlett Packard (HPQ) reported after the close and was down nearly 8% at last check.)

   As today's market showed, a couple weeks of gains can be lost in a day. An interesting look at the best yearly starts in stock market history shows nearly all gains being given back in the first quarter before almost always moving higher toward the year end. Will this year be the same? Revolutions in the Middle East are creating significant headline risk and continue to spark upward pressure on oil prices. Something to consider, rising oil prices act as both a tax on the consumer and have a deflationary effect. As the Middle East consumes the headlines, European sovereign debt has been pushed off the radar. However, Portugal's yields have been moving higher and remain above 7%, the level that forced Greece and Ireland to accept bailouts. Don't be surprised if Portugal is forced to accept a bailout before the month's end. Also, austerity is starting to take hold at state and local levels in the U.S., as witnessed by recent rallies and shutting of schools in Wisconsin. These factors will all likely provide headwinds to the economic recovery and stock market as the year moves along.

   In regards to individual stocks, I recently sold my position in R.R. Donnelley (RRD) after a 20%+ gain. Although it's underperformed the market in the past couple months, I'd still recommend Abbott Labs (ABT) under $47. After today's move, I'd recommend starting positions in Microsoft (MSFT), under $26.70, and Astrazeneca (AZN), below $48.50. If the sell-off continues further, I'd look to add Walmart at $53. These suggestions are meant for investors with a time horizon of at least 2-3 years.

Disclosure: Author has no position in RRD but holds long positions in ABT, AZN, MSFT and WMT.