The Untold Truth Of Why Stocks Crashed This Earnings Season

The Untold Truth Of Why Stocks Crashed This Earnings Season

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These are not penny stocks, as the volatility would assume. In contrast, these are one-day crashes of multi-billion companies on earnings day.

I could have made this list way longer. I don’t know about you, but I have never witnessed such a volatile earnings season as the fourth quarter of 2021.

Interestingly, most of these companies seem to have reported strong Q4 earnings. Indeed, data shows 75.8% of all S&P 500 companies beat EPS estimates, significantly higher than the 72.0% historical average.

So why did so many stocks plunge during earnings season, despite having beaten estimates? And what does this imply for future returns of these and many other stocks in the market?

In this article, I will provide an answer to these questions which I believe has not received enough attention in the market. The content provided in this write-up is not only valuable to get a better understanding of today’s unusual market environment, but is also an important lesson for your future investment journey. Taking a Step Back: Market Volatility Explained

The fair value of a company is based on all future cash flows discounted to today. Investors who can keep remembering this rule during extremely volatile periods (both on the up- and downside) will generate much better returns than those who forget about it. Let me explain this further.

The DCF valuation method says that the valuation of a company is based on all future cash flows discounted to today. Importantly, more than half of this “fair value” is based on cash flows more than 10 years away from now, which are very hard to accurately predict.

Due to this uncertainty about cash flows in the distant future , analysts and investors focus highly on short-term earnings. That’s despite the fact that first year’s free cash flows actually represents <5% of the average company’s fair value.

When companies report strong earnings/guidance, market participants tend to overreact on the upside. They push the stock higher without thinking about the sustainability of this strength in the future, which is far more important.

When companies reports disappointing earnings/guidance, market participants drop the shares no matter what. They forget to think about what drove the earnings miss and find it hard to visualize an improvement in the future.

Or to put it in the words of billionaire entrepreneur Peter Thiel: Growth rates get overvalued, while durability gets undervalued. Sentiment-based earnings volatility creates this very interesting trend which can push the stock price (red) significantly above/below the intrinsic value (blue) of the company: Insider Opportunities FOMO will cause many retail investors to jump into a stock when its sentiment is sky high. They think “the company is growing extremely rapidly and the stock price has only been going up, I should jump in as well” without considering the valuation nor the sustainability of the growth rate. They buy high and sell low when it appears that this growth rate was not durable.

The smart investor does the opposite: Thinking one step ahead of the market. He acknowledges when valuations are getting too high as strong earnings push sentiment to extremely greedy levels. He buys stocks which deserve little respect from Mr. Market for unjustified reasons and are set to positively surprise the market in the coming 6-12 months.

I sincerely hope that after reading this article, you will join me in the second group of investors. What Really Happened Last Earnings Season

Sentiment-based volatility has been occurring day-in, day-out since the existence of the stock market. However, the past two years has been an extreme outlier.

In 2021 we experienced an unprecedented economic recovery from the COVID-19 pandemic as central banks pushed trillions of dollars in the monetary system. Earnings went through the roof and investors became extremely bullish. Unfortunately, most investors forgot to think about the bigger picture here. This financial strength was not durable. The recent sell-off build-up

Since late 2020, I started to warn investors about the unsustainability of the strong earnings reports at high-flying tech stocks .

In September 2021, I went a step further by calling out significant risks for the entire market in my article ” Zoom’s Steep Earnings Sell-Off Should Change Your View On The Market.”

I urged you to reconsider all of […]

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