We monitor whether investor expectations are getting more optimistic ahead of earnings as a sign that a stock may be at risk of the "sell the news" crowd stepping in after earnings. Investors should avoid (or short) such situations. Why? The upside potential of a positive earnings report is limited, because the market has already priced the stock for perfection.
Typically, you want to see a company report strong earnings when investors expect a weak report. A stock will usually rally more than average, as skeptical investors rush in to buy shares to play catch-up. That added buying pressure tends to force prices higher.
With that, here are three behavioral rules to remember during earnings season. Refer to them
regularly, as these simple rules have stood the test of time when it comes to earnings season
Avoid the temptation of running with the crowd. The crowd tends to get whipped into a frenzy ahead of an earnings announcement, as investors buy a stock based on their positive expectations. This means that the stock price reflects ambitious expectations, which are often hard to meet. Under these circumstances, a stock that reports positive earnings will likely sell off because of its bloated behavioral value.
Look for the under-appreciated opportunities.
Keep an eye on companies with low investor expectations headed into earnings. In contrast to rule number one, low expectations are easily met or exceeded beat. That's when investors move in and drive prices higher. Pay attention to rules one and two.