- Warner Bros.
Earnings season is growing in significance for money managers amid bigger price fluctuations and deeper risk to the downside.
- Much of the blame is being assigned to the rise of exchange-traded funds.
- Investors aren’t yet effectively positioned to benefit from this new volatility regime.
If you want to make money in the stock market, you’d better nail earnings season. Or else.
The reason is simple: quarterly results are exerting unprecedented influence over stock returns and, by extension, portfolio performance.
In recent quarters, reporting companies have seen their shares move four times the normal daily average, the most in the past 18 years, according to data compiled by Goldman Sachs. That’s the type of volatility for which traders have been starved in a market that’s been sapped of the price swings that normally create money-making opportunities.
But it doesn’t end there. Amid all this talk of generating positive returns, the punishment for missing earnings is also the harshest in almost two years. In the first quarter of this year, companies that fell short dropped more than 2.5% in a single day, on average, Wells Fargo data show.
And while there’s no single reason for the rise of price swings during earnings season, the rise of passive investment vehicles such as ETFs and quant funds has absorbed much of the blame.
By trading large swaths of the equity market, rather than individual stocks, participating investors are diluting the effects of specific company fundamentals. This is then compounded by how price-insensitive these traders can be — buying and selling based on what their models tell them, and ignoring valuations that might otherwise raise red flags.
This isn’t going unnoticed by large institutions that depend on beating market benchmarks to make money and attract new client capital. Dmitry Balyasny, the managing partner at $12.6 billion hedge fund Balyasny Asset Management, finds that earnings have taken on renewed importance.
“Day-to-day action is very ETF-driven,” he wrote in a recent investor letter. “Portfolio construction needs to be tight and tilts need to be very well managed to navigate these powerful flows. This makes catalysts, earnings, and other events extremely important to play — and play correctly — because that is when dispersion is most likely to occur.”
It doesn’t yet look like investors have caught on. Despite the outsized earnings fluctuations occurring throughout the market, options are implying an average move of just 4.6% in either direction, near the lowest on record, according to Goldman data. In order to take advantage, the firm recommends placing strategic options bets designed to benefit from large price swings.
It’s a suggestion that should be heeded, especially considering how important earnings results currently are for the market’s hottest stocks. Goldman finds that the FAAMG group that’s led the stock market’s latest rally to new highs — consisting of Facebook, Amazon, Apple, Microsoft and Google — has been realizing more than 50% of its quarterly return during earnings week.
In addition, the tech, materials and consumer discretionary sectors are also seeing more than 30% of their quarterly returns generated in the five days surrounding releases.
“Some of these reactions are downright insane,” Robert Pavlik, chief market strategist at Boston Private Wealth who helps oversee $9.1 billion, told Business Insider. “With hedge funds and high-frequency traders making these instantaneous moves, the average retail investor tries to match what the pros are doing. Earnings season only serves to facilitate this whole system of trading and making short-term decisions, and thus increases volatility.”
Still, there are some drivers very specific to the current macroeconomic environment that are boosting the importance of earnings, outside of passive investment.
For one, equities are trading at or near record highs. So for active managers for whom price does matter, there’s some trading potential in picking stocks viewed as overheated. Additionally, the Federal Reserve is unwinding its unprecedented monetary stimulus, which can have a polarizing effect on full sectors.
“Earnings are more important this cycle,” Bruce Bittles, the chief investment strategist at the Milwaukee-based Robert W. Baird, told Business Insider. “That’s given the high valuations and the fact that the Fed is now in tightening mode”
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