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In This Topsy-Turvy Market, It’s Time to Start Reading the Tea Leaves

By Linda McDonough on April 25, 2018

Being a stock analyst is a tough job. From the outside it seems natural; Find a company with strong fundamentals and growing earnings, then buy the stock and watch it rise. Feeling bearish? Find a clunker with many headwinds and short it. Collect your cash as the stock melts.

This fairytale scenario is unlike any day I’ve ever experienced in the stock market, but recent cross-currents are making an analyst’s job even more difficult.

Recently, making bets on individual stocks feels as dicey as walking a tightrope or entering a lion’s cage with a chunk of fresh meat.

Whenever the market is between a bull and bear trend, stock movements can make you queasy. This particular earnings period feels unusually turbulent. Stocks are flat or dropping on robust earnings and gapping up on earnings misses.

When stocks don’t move expectedly, it is time to read the tea leaves. These unexpected stock moves often contain valuable information. Sometimes as an analyst getting the numbers right on a stock is the easy part. It’s getting the stock movement correct that is harder. And deciphering investor sentiment from these gyrations is critical to finding profitable ideas.

The Bull Case

According to FactSet, companies are estimated to report an 18% increase in earnings for the first quarter.

This growth rate is the highest in over five years and a remarkably high one. With almost twenty percent of companies already reporting earnings and 80% topping analysts’ estimates, one would imagine the stock market would be roaring higher.

But of those beating estimates, the average increase in the stocks was a meager .1%. You may need to squint to see that decimal. Yes, despite double-digit earnings growth and an average 6% earnings beat, the stocks barely budged.

Of the twelve stocks that beat earnings estimates by the widest margin last week, only seven rose significantly. Of the twelve that missed estimates by a mile, half declined, and half were flat to slightly up.

The bullish scenario is that investors are nervous and the sell-offs will be temporary.

Volatility is alive and well in the market, and short-term traders are likely taking profits. Many stocks that closed down on good earnings, like Nike (NYSE: NKE), rose immediately after reporting only to see those gains swamped by sellers.

And then there are stocks like CarMax (NYSE: KMX) and Hasbro (NYSE: HAS) that missed estimates badly. Hasbro reported revenue of $716 million, $100 million LESS than expected and earnings per share of $.10, one-third of the $.34 expected. The stock is up 3% as of this writing.

The Bear Case

The bearish scenario is that the golden days of beating estimates and raising guidance will not be so predictable. With tax cuts contributing to a significant portion of higher earnings and several new accounting standards being implemented this quarter, analysts are more skeptical of headline beats.

I’ve seen much more discernment for bullish commentary. The economy has had a big run and inflation is starting to pick up. The glory days of beating earnings due to better revenue trends are getting long in the tooth.

To see significant upside stocks will need to prove that they can balance revenue growth with improving profits and a plan on how to handle higher costs going forward. Skyrocketing transportation and labor costs are sucking away much of the joy investors had expected from robust demand.

No one ever said fairy tales all have good endings. But they are always entertaining. If you pay attention to the tea leaves and get a coherent read on investor sentiment, you’ll find some great trades.

At my Profit Catalyst Alert newsletter, I lean on my 30 years of experience researching stocks to help untangle these cross currents. When trading patterns finally showed some warmth to the bears, I issued several bearish put recommendations which have delivered double-digit returns. But I’ve got some bullish calls too for those stocks that have the wind behind their back.

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