The first quarter earnings season starts in early April, and this will confirm or refute the 2013 stock market's strong advance. It is important to note that stocks keep advancing even though 101 companies in the index have issued negative earnings preannouncements for the first quarter.
By STEVEN M. SEARS
SATURDAY, MARCH 16, 2013
Barron's
It will soon be truth-or-consequences time on Wall Street.
The first-quarter earnings season starts in early April, and this will confirm or refute the 2013 stock market's strong advance.
To be sure, it's increasingly fashionable to note that the negative preannouncement earnings rate among S&P 500 companies is at the highest level since 2001's third quarter.
Yet stocks keep advancing, and benchmark indexes are around record highs, even though 101 companies in the index have issued negative earnings preannouncements for the first quarter, compared with 23 positive ones, according to Thomson Reuters I/B/E/S.
Shrugging off bad news is a hallmark of a bull market, and a potential sign of investor complacency. "The only thing we have to fear is the lack of fear itself," says Steven Sosnick, a senior trader at the Timber Hill market-making unit of Interactive Brokers Group (ticker: IBKR), riffing on FDR's famous remark during his 1933 inaugural speech.
For proof of the absence of worries, one need only consider the fear gauge, the CBOE Volatility Index.
The VIX is trading at its lowest level since those halcyon days of 2007, when investors had nary a care in the world. We all know how that ultimately turned out. But do they have anything to fear now?
Alcoa's (AA) first-quarter earnings report, set for April 8, will provide an indication. Aluminum sales aren't a great harbinger of economic activity. But symbolism influences psychology, and psychology influences stock prices.
What happens if the first-quarter earnings season is bad? Maybe nothing, because the season still might look really good. After all, bad news is now being flushed out of the market, as analysts cut their profit forecasts before the earnings season begins. Investors might bid up stocks of companies that preannounced, especially if those companies crush the lowered estimates. (That's the Wall Street two-step.)
FOR THE PAST MONTH, this column has advised readers to hedge the stock market's advance with inexpensive puts on the SPDR S&P 500 ETF Trust (SPY). With hedging costs low and equities' prices high, it made sense to lock in gains. The logic was right, but the advice was mostly wrong, except for one day when stocks fell a few hundred points. Disciplined investors cashed out that day, and others learned a lesson about hedging and how the stock market often does the unexpected.
So, the reaction to bad earnings preannouncements was to straddle or strangle the earnings season by buying May puts and calls on the SPDR S&P 500 ETF Trust. Yet, when pricing the strategies that would prove profitable if the stock market advanced or declined—yes, it's a high-class coin toss, but c'est la guerre—the big surprise was that the strategies were very expensive, even though the VIX was—and is—very low.
The SPY May $155 straddle—which entails buying puts and calls with strike prices equal to the price of the associated security—was so expensive that the stock market would have to rise or fall some 7% or more for the straddle to be profitable.
When a straddle is too expensive, or you want to risk less money, strangles are usually a viable alternative.
The strangle entails buying puts and calls with strike prices above and below the associated security's price. Well, the strangle didn't offer big savings compared with the straddle. This shows that the options market expects stocks to make a sharp move, up or down, during earnings season—and the move is priced into both put and call prices.
Which way will the market go? If you're bullish, sell puts and buy calls. If you're bearish, buy puts and sell calls.
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