Earnings season is always a volatile time on Wall Street, but this quarter has so far been especially volatile as traders seem to be selling into earnings strength.
Selling into strength is the practice of waiting for good news to send a stock that you own (but have lost confidence in for the longer term) higher before exiting your position so you can take advantage of higher prices and increased liquidity.
We have seen this pattern play out time and time again this week as companies have smashed earnings expectations, sending their stocks higher in extended-hours trading, only to see those same stocks sell off once the opening bell rings.
For example, Caterpillar Inc. (NYSE:CAT) revved up the selling-into-strength phenomenon on Tuesday when it shattered its first-quarter expectations by announcing that it beat revenue expectations by $970 million and earnings expectations by 75 cents — coming in at $12.9 billion and $2.82 per share, respectively.
As you can see in the 5-minute chart in Fig. 1, this news sent CAT higher in pre-market trading (yellow background).
Fig. 1 — 5-Minute Chart of Caterpillar (CAT)
However, once the opening bell sounded and management announced on the earnings conference call that it believes the profits generated during the first quarter are likely to be the “high watermark” for 2018, traders started selling the stock and taking their profits off the table, sending the stock dramatically lower during open-market trading (white background).
To better understand why CAT sold off like it did, it’s important to understand the components of an earnings announcement.
Components of the Announcement
When looking at the earnings announcement itself, there are three key pieces of information you need to pay attention to:
- Revenue
- Earnings
- Forward-looking statements
Revenue is the least important of the three components. It is backward-looking and tells you how much money a company is bringing in from operations. Rising top-line revenue indicates that the company is growing, which is a good sign for the future of the company.
Earnings are the second most important of the three components. They are backward-looking and tell you how much of the money the company brought in on the top-end has actually flowed through the company and made its way into the “pockets” of shareholders. A rising bottom line indicates that the company is generating profits, which is a good sign for shareholders. As we have seen during the past few years, companies can increase earnings by improving efficiencies and cutting costs without commensurate top-line revenue growth.
Forward-Looking Statements are the most important of the three components. As the name suggests, these statements are forward-looking and tell you what management expects the company to do in the future. If these statements are positive, traders will often be willing to pay more for the stock with the expectation of increased earnings. If these statements are negative, traders will not be willing to pay as much for the stock.
CAT jumped initially because its revenue and earnings were strong. However, once traders found out via the forward-looking statements that management’s outlook for the future did not entail accelerating growth, they took their profits.
The Bottom Line
Keep an eye on the forward-looking statements. Nobody seems to be questioning the idea that the first quarter was a solid one in corporate America. However, confidence that the second, third and fourth quarters are going to be just as strong — or stronger — seems to be slipping a bit.
You can learn more about identifying price patterns and using them to project how far you think a stock is going to move in our Advanced Technical Analysis Program.
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