Market Strategy Report

It’s earnings season – which means stocks should be in play based on their individual merits, not the macroeconomic environment, or lack thereof. As a trader, I made the bulk of my living during earnings season. My favorite plays were looking to buy beaten down stocks that had come in with a modest gain or even flat, while shorting strong stocks with the same earnings profile.

It turns out that this strategy has some fairly sturdy data to back it up. In a 1995 study published in Financial Analysts Journal (not online), David Dreman and Michael Berry showed that low p-e stocks, those in the bottom third of stocks, gained 20.5% when beating earnings, while the top third gained only 6.63% on average. When those low p-e stocks missed earnings, they fell 4.17%, much less than the 18.49% drop suffered by the high p-e stocks. Even over the longer term, the numbers bear out. The low p-e stocks were up 9.39% after one year when they beat and up .74% when they missed, compared to .32% and -9.54% for the high p-e stocks.

These numbers were culled from the years 1973-1993, which made me wonder if the theory still holds true, especially in a market where investors are more inclined to sell first and ask questions later. I asked Forester Value Fund’s Tom Forester, manager of 2008’s only positive U.S. equity fund, whether he thought he could still count on the same behavior (he was the one who first showed me the Dreman/Berry numbers). “Absolutely,” he said. “A lot of companies are missing right now, and the companies with lower expectations in them weather the storm better than those with higher expectations.” He pointed to State Street, a stock that had performed relatively well until it missed earnings on Jan. 20 and dropped over 50%.

What does that mean for this week? Look for stocks that have been beaten up to get a bounce if they can modestly beat earnings – AXP, ZION and CAT are three releasing Monday that are trading near 52-week lows. AMGN is near a 52-week high – be careful if it disappoints.