Parsing Trends Into Earnings: How Will Netflix And Twitter React To Today's Earnings?

“Acheter les canon, vendre les clarions”

(Buy the cannons, sell the trumpets)

It’s not a very difficult concept to grasp for trading: sell winners when the market is overvaluing their fundamentals. Still, it's difficult to internalize; parting ways with a position that has treated us well is so contrary to any other part of our lives.

When a price rises considerably for an extended period ahead of an earnings announcement, perhaps that winner’s fundamentals are being overvalued; perhaps not. This earnings season, what behavior will indicate whether a stock's value – near-term, at least -- has been fully realized?

Yahoo! YHOO has greeted its two prior earnings with trending that tried unsuccessfully to extend. Earnings triggered gaps in the opposite directions Twitter TWTR had trended ahead of its earnings, and also had tried unsuccessfully to extend the trend. Unlike YHOO, TWTR did react down.

Think of earnings as a report card with grades reflecting whether the student’s social behavior interfered with his learning. A stock behaving too optimistically ahead of earnings is like the student who acts cocky on his way into the quarterly-exam room – too cocky, after partying all semester instead of studying.

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Those stocks are ripe for shorting, selling, or just not buying. Not an extended stock, which has been rallying for weeks ahead of the release, probing higher highs. But a stock that has only recently begun bouncing, just days ahead of earnings. That stock is probably only temporarily strong.

Already having discounted most of the bad news that was on its way, bouncing was unavoidable. The reaction to the actual news then triggers a retest of the low, perhaps also resuming the decline.

Netflix’s NFLX earnings in April is one example of already having discounted most of the negative expectations. Weeks and weeks of decline began retracing ahead of earnings. The immediate reaction to earnings was a significant gap up. But that created too much positive in the price and the decline resumed.

Citigroup C has a recent history of overly discounting negative expectations. Trending down to new lows ahead of April’s earnings was rejected strongly. Not that the news necessarily changed the outlook – price largely ranged sideways into last week’s earnings, which triggered a gap up.

Biased Trends

Relentless trending -- rallying or declining -- into an earnings event is typically the product of broad-based bias. Multi-session moves are not the work of just a few “insiders.” What is behind this widespread agreement? If not fact, then it must be opinion.

When the majority of market participants are overwhelmingly in agreement, a surprise is difficult. The collective opinion may already be discounting all of the positives or negative that the news can deliver. The earnings reaction – perhaps after the first day or two – often starts reversing.

Intel’s INTC earnings last week greeted a relentless ongoing rally. The news apparently confirmed expectations, perhaps enticing the last bit of patient buyers to move their limit orders to market orders. The gap up reflected the bias confirmation. Does the narrow ranging since then mark the beginning of a long-awaited correction?

> MCIG MTG had trended down considerably in a brief time ahead of last week’s earnings. The reaction was down, appropriately. But despite having plunged for a week prior, the two sessions following earnings have remained within that session’s range. Recent opinion was correct ahead of earnings, but only ranging since then might be preceding a recovery attempt.

Even if earnings justified a recent price rise, it rarely justifies rising much more. Being quarterly, the next earnings report is now three months away. To be sure, other news stories and corporate announcements will fill the interim. But earnings news, the motivating factor behind the recent broad-based buying, will fade. The price might shrink as earnings news-triggered demand similarly vanishes.

There is a price to pay for being early to a story, but the tab is higher for staying too long, or for getting involved too late. When everyone is excited about a story, that can be the worst time to buy.

Anticipating the market reaction to NFLX and TWTR earnings:

NFLX and TWTR will announce earnings after Monday’s close.

NFLX seems to have formed a "Head & Shoulders" pattern since mid-June, consolidating at the pattern’s “neckline.” After probing unsuccessfully under the neckline support, markets are likelier to react up sharply to positive earnings. If that happens, however, not much time is likely to be spent at new highs before reversing down sharply.

Meanwhile, TWTR seems to be forming the same pattern as before last quarter’s earnings. Volume didn’t expand into the dowdraft, so an immediately favorable up down on good earnings is more likely.