Part Three: RED LIGHT, GREEN LIGHT
Part Three: The Red-Light, Green-Light System, by Wade Cook NEWS: CHANGING PERCEPTIONS
Okay, let’s start down the path. It’s about June 15—a few weeks before the quarter ends. People start to talk. Analysts adjust and readjust their expected earnings numbers. The CEO of Big Company comes out in interviews or news releases and downplays their numbers, saying something like, “Sales have been good, but we have a charge off, so earnings will be $1.12 instead of $1.32.” The stock drops $5, from $86 to $81. Now toward the end of June other news—rumors mostly as the company hasn’t released its actual SEC filings yet. Rumors could be about mergers, share buy-backs, takeovers, stock splits, other sales figures, new product announcements, et cetera. These impact perceptions about the company. The stock wavers but heads back up.
The year or quarter ends. There is no talk from the company. This is a very quiet time. Outsiders may speculate, but the actual numbers are kept secret. The company brass is mum. No one, and I mean no one, wants to be in violation of the regulations. You see, people can’t trade on news the general public does not have.
So, we get ready for earnings. Of all these newsy items, the type of announcement most followed is any announcement having to do with earnings. I’ve written about earnings, or P/E, in many other places. Many people base what they are willing to pay for a stock on the P/E, or price-to-earnings ratio. A typical NYSE company has a P/E of around 19—let’s say 19.2. In short, this means that the stock ($5, $50 or $500 stock price) will cost $19.20 for every $1 of earnings. The stock may be at $250 or $5 or .50¢, it matters not. Now a static or isolated P/E is not the only factor in price determination even for those who only follow P/Es. Other important considerations include these questions: Are earnings growing or contracting? How does this company’s earnings compare to those of other companies? Are earnings even a viable measurement in certain sectors?
Back to the point: Earnings is the most widely watched measurement of stock values. Because of this, all CEOs must be very careful of what they say about earnings.
Let’s move down to the first week of July. The quarter is over, but the actual filing (l0Q) has not yet been filed. That will happen in a few weeks—at least by August 15, the filing deadline. Now, think this through. If the CEO, CFO or other corporate bigwigs comment about actual numbers before the proper documents are filed, it is assumed that he or she knows what the numbers should be. Do you see?
Even if the accountants aren’t through with the complete consolidated statement, it would be determined that he or she should know. Because of this there is a complete news shutdown (shh! no talking, no talking!). No one will talk until the l0Qs are filed and the news release is out. Funny thing—the stock gets back to $86 and even up to $88. How does this happen? There is something happening here. Paranoia strikes deep. It is as if a whole group of people knows something we don’t know. In fact, we’re the last to know.
Here’s the pathetic, yet comical irony. Now the news is out—it’s official. The interviews or press releases start up with something like this: “Earnings are ahead of expectations by about 10%. They are $1.22 per share.” As the report goes on, you’ll see an interesting twist. “We’re pleased with the numbers and growth, but we contemplate a slowdown in sales next quarter (or year) and may not be able to maintain these high numbers,”
Is this crazy or what? They good-mouth and bad-mouth their numbers in the same breath. Why? You must understand the fear these CEOs and others live under. They do not want to be seen hyping their stock. They couch the truth behind caveats. They pad everything. This is the way it is.
Now another unusual thing happens. Many times the stock goes down in spite of good news. It is a strange phenomenon. I’m still perplexed when it happens. It’s part of the “buy on rumors, sell on facts (news)” syndrome. Sometimes it has to do with what has happened to the stock in the few weeks or months before the report. It has a lot to do with sentiment—expectations and the like. There are too many variables to mention in this chapter. It’s a mystery wrapped in a conundrum engulfed by an enigma.
THE BOARD MUST MEET
Based on many other news developments, so goes the stock. One event is particularly important: the Board of Directors meeting. The date of this event can be checked out, and nothing happens until they meet. This is significant. They discuss profits, available cash for dividends, mergers, share buy-backs, stock splits, business plans, et cetera.
Do you see how important these topics are? Think of all the guesswork going on by people following the company. Rumor fires are easily kindled. Sometimes they get out of control. However they start, whatever they are, it all ends when the actual numbers and news hit the street.
All of this is very important, but then what? Where’s the sequel? Where’s the new news? It’s now the end of July or first week of August. (The same could be applied to the end of the October/November or January/February or April/May periods.) The news is out. We don’t have to wait as long as we have for Star Wars: The Force Awakens to come out in the Star Wars series, but wait we must. In short, in the absence of news, “this stock ain’t going nowhere.” The balloon isn’t going up without hot air. The car isn’t leaving the garage without gas. Superman isn’t flying without his cape. Sorry Hans, I couldn’t work you in.
Here’s a problem. What if we purchase stock at the height of this incredible (pre) news time? The stock has risen to $92. A big firm puts out a buy rating. Others follow. The company has even announced a stock split for August 20, a Friday. It just looks peachy—how can you lose?
Oh, and what if you like options? Those funny little derivatives that rise and fall as the stock does—and erode as the time moves on toward the expiration date.
Options present an awesome opportunity to make money as long as the stock moves exactly like you want it to. If you buy a call option, the right to buy stock, you want the stock to go up. If it goes down or stays the same, you lose. Now ask yourself: Why am I buying this option when all the news has played out? At least ask, why did I buy the option with a near term expiration date? Maybe I should have bought the option with an expiration date at least into the next news-reporting period.
Now all in all, observing this “news—no news” period should help us make wiser decisions. Decisions when to get in, decisions when to sell. Here is an important question: “What compelling reason does this stock have to go up?” More importantly, what compelling reason does this option have to go up in value? The answer is simple, but far-reaching. If there is nothing to drive it up—no news, no rumors, and no nothing—then watch out.
Do you see where I now come up with “Red-Light, Green-Light?” A time to buy—a time not to buy. Now, notice I didn’t say a time to sell. There are times when we should not be buying options. This goes back to a premise I’ve taught for years: the way to win at the stock market is to not lose! We need to avoid making mistakes. Buying a call option when a stock has nothing going on to help drive up the price is likely to be one of those mistakes.
© 2015 Wade B. Cook. All Rights Reserved. Receive Wade’s newest book: STOCK SPLITS, at wadecook.org