Surely everyone has suffered/enjoyed a sudden movement of a stock in a portfolio when the underlying company has reported earnings. Now that the earnings report season is starting you may wonder if there exists a way to avoid those shocks in the stocks without missing performance in your investments.
How often are earnings shocks?
In order to analyse the impact of the earnings publication in the returns of the stocks we are going to analyse the components of the S&P 500 index. To do so, we will examine the stock returns (measured with close prices) of the companies in publication dates – actually we are considering 2-day returns, including the return of the next date of publications, since I do not have at hand if the publication is before, during or after the market has closed, so I don’t know if the publication influences the close price of the publication or the one of the day after.
In order to measure the intensity of the returns, I obtain the (percentage) ranking against the companies in the same sector; that is, if a company’s return rank is close to 0, the return that day will be one of the lowest in the sector, if it is close to 1, it is one of the highest of the sector. I have also compared the returns ranking of the whole S&P 500 universe (“all”).
In the histograms below you can verify that our intuition was right: no matter the sector, the density curves of the returns rankings during earnings publication dates are not precisely normally distributed; quite the opposite, since the frequency in the extremes is always the highest.
Looking at the above histograms your doctor would recommend you to avoid investing in publication days in order to prevent a heart attack due to excessive joy or pain shocks. What prescription can we give to ease these moments in the market without missing the market performance?
Get out during earnings presentations
The first proposal is the obvious one: Go away from the companies that are presenting results. In the following test we are going to assume that our base portfolio is made up of all the components of S&P 500 with the same weight; when a company presents results we assume that that day and the following the stock is not bought and has return 0.
Comparing the results of a portfolio fully invested in the components of S&P 500 and a portfolio with the proposal implemented (No Earnings) we realise that the results do not change drastically: the final performance is slightly lower with the proposal (but not during the whole simulation), has lower runups, and the risk decreases in terms of volatility and drawdown:
Go to market
Another possible policy before the presentation of earnings reports is to replace the stock of the company that publics results and go to a different asset, reducing the possibility of falling into a return shock. There could be endless possible policies to choose a substitute asset: replace the stock with its sector (an ETF for example), with an asset representing the index, with an asset highly correlated, etc.
In the example presented here we just assume that the target stocks are replaced by the the mean return of the components of the S&P 500 during the day of publication and the day after.
As you can see in the results below (no fees included), the performance is similar and slightly higher with this policy proposed, and the drawdowns and runups are barely improved.
All of this suggests that in the long run the extreme returns observed during earnings report publication dates get diluted along time and do not differentiate a lot from being invested in the broad market.
In this post I have analysed the pattern of the stocks returns during earnings publication dates, that showed extreme rankings very frequently. I have studied the impact of avoiding the investment in those stocks in earnings publication dates, showing that it is possible to implement policies to avoid those periods without impacting the results in the long term.
I leave for a future post the possibility of taking advantage of the behaviour of the stocks during earnings presentation to decide the policy to follow in subsequent earnings publication dates.
Hope you liked the post and do not hesitate to sharing with us your thoughts or strategies regarding this topic!