Morning Market ThoughtsThis week is the start of earnings season. While it is always important to know how a company has performed over the last quarter, the critical element in an earnings release is the forward guidance. Is the existing forward reaffirmed by the company, or are they giving “soft” guidance? Are they raising their estimates for 2017, or do they sound uncertain? Since the market tends to look about 6 months ahead, the results of Q2 earnings are likely already baked in to the price of the stock. If the market has been really bullish on a company, then the stock is probably already extended upward in anticipation of those earnings. If the market has been really pessimistic about the company, then the current stock price might already have a bad number factored into it.
If earnings results are strong, will an upward extended stock really move higher? Isn’t it already up quite a bit and perhaps extended from the most recent base? If so, then all the bulls are already in the stock. How much more aggressive buying pressure will there be?
On the other hand, what if earnings results are worse than expected? Well, if the stock is extended above the last base, it’s likely to fall. But if the stock is already down at extremely low levels (bottom right corner of the chart), then even poor results might lead to a rally on the stock.
Here’s an exercise: Check out Chipotle Mexican Grill (CMG). That stock has been in a basing pattern for nearly a year. It’s slightly extended above the current base, but that could change between now and April 25th, when the company reports Q3 earnings. The E.coli bacteria issue has really weighed on the stock because there are no longer any long lines at CMG. You can basically just walk right in and order. Why? Nobody wants to get infected by the E.coli bacteria. That’s why the stock fell from $750 down to $360 in just a year. That’s right — a 50% haircut in market cap because of a microscopic bug with a very weird first name (Esterichia) that nobody wants to share their food with.
The stock has been trading in a range from $380 to $440 since last June, with a couple of brief detours down to $360. So the stock has been under pressure. If you want to buy some, you can buy it pretty easily. Here’s my definition of a base: A stock in a defined range of equilibrium at the bottom of your chart. So CMG has been in a base, right?
But just last week the stock broke out of the base and is now up at $447. Could this be the start of a runup in anticipation of better earnings? It’s too soon to make that call because the results aren’t published for two weeks. A lot can happen between now and then. But watch it during the next couple of weeks. Frankly, if it continues to move higher today and/or tomorrow and pushes above $460, then I’ll probably buy the stock because I want to get in on the action with a Trading Places strategy: “Hey, the Dukes are trying to corner the (CMG) market. They know something. Let’s get in on it!”
So if CMG starts moving higher over the next two weeks, then what do you think can happen when the earnings are released? Buy the anticipation, sell the news! A pre-earnings rally can lead to a post-earnings hangover. We could see the stock drop, even though the earnings report is pretty good.
But what if CMG stays stuck in the current $380-$440 range? When we could see a pop even if earnings aren’t great. The reason? Traders weren’t expecting much. In fact, they expected worse! So it could be that the worst days are behind it — and that means that there are better days ahead. And that takes us back to the top of this note — The market looks ahead by about 6 months. So if the worst days are behind Chipotle, then that means that the next 6 months will likely be better. And if that’s the case, I want to buy right now.
So watch how CMG acts over the next couple of weeks. The trade will either present itself right now…or we’ll be able to wait until earnings and then make the trade. But one way or the other, there’s a trade to be made on CMG around the earnings report.
And by the way, you can apply this analysis to every single stock that you are trading. They all trade according to the laws of anticipation and reaction; supply and demand; optimism and pessimism. When you think in these terms rather than flipping a coin, you’ll actually look forward to earnings season rather than dread it.
Let the games begin!