I recently watched a video on YouTube where the viewer sent in a question wondering why and how a stock could have a great earnings report and still drop more than 20%. The exact question was:
“I have been trading for a year and a half now and I am a momentum trader. The latest big lost was a stock I own earnings just came out the other day which klled all estimates but it has been diving the last few days by about 20%+.”
“Since listening to your episodes, I normally don’t hold during earnings season, but I took a chance and it cost me big-time!.”
“Do you have any thoughts on this? Any insight would be helpful. Thank you!”
Immediately I knew the answer to this question and continued watching to see how the YouTuber would respond as the “subject matter expert”. Now I’m not going name any names or hashtag any YouTube channel, but I must say I was quite disappointed by his response, although not much surprised. I know this YouTuber has been studying the stock market for much longer than I have, so therein lies the source of my disappointment.
Now the YouTuber wasn’t necessarily wrong. He gave a very complex explanation that failed to really deliver the point as the how this divergence between positive earnings report and negative price action could occur. Really, this question could have been answered in about a minute with another question: “Have you watched the news lately?”
Now that I typed that out, I realize that wouldn’t be much help either with the level of confusion added to the selloff chaos from headlines of various news articles. To give a better answer to the question, the selloff of the broader market is the reason those exceptional earnings means little for that stock’s performance.
Does this mean that all stocks should be dropping like a bag of bricks from a skyscraper? Of course not. I’m sure some stocks can be found that has found some strength in this weak market. (Permabull perspective)
However, we must remember the stock market is more about the investors and traders involved than the actual companies we are betting on. The change in price, a result of supply and demand, has more to do with the reactions of market participants than how well Company XYZ has performed for the quarter.
This is the main reason why seasoned investors like Warren Buffett see so much buying potential in bear markets. They understand the companies they are invested in to the point where they have a good sense of if that company can survive the emotional rollercoaster of irrational market correction.
Many investors, like the one who asked the question, fail to grasp this concept and get eaten alive as a result when things go haywire. This is another reason why conventional wisdom tells traders to not hold stocks through earnings because no one knows how the overall market will respond to the news.
There are actually many more factors involved as to why stocks move irrationally the way they do through earnings but the least of those reasons has to do with the actual performance of the company.
As retail investors and traders, the only thing we need to be aware of is that things will rarely go the way we think they will and decide if we want to play the rollercoaster game or get out and wait for things to return to “normal”.
As I previously mentioned, the main thing to keep in mind is that stock prices have more to do with the people than it does the company. The people invested are the ones that directly affect the movement of price by their trading actions, usually based on emotions. And I didn’t even mention the algorithms created by those same people that contribute to much of the wild swings in price action, mostly seen intraday. But that’s another topic for another day.
Stay calm. Make a plan. Trade the plan.