Reuters / John Gress
- Ahead of third-quarter earnings, Citi’s quant strategists have updated their model that predicts which stocks would rally in anticipation of strong results.
- They detailed the most important factors that play into the model, and companies that are expected to outperform in the weeks ahead.
Earnings seasonis almost upon us once again.
The big banks, including JPMorgan and Wells Fargo, are scheduled to report their third-quarter earnings in the second week of October, marking the unofficial start to the deluge of results that will follow.
Profit growth is considered the most-material driver of stock prices, and so earnings reports are typically the most-significant market movers. Traders looking to profit from outsized moves during earnings season can find great opportunities in companies that surmount expectations.
But there’s a “better way” to profit from earnings surprises, according to Hong Li, the head of equity quantitative strategy at Citi: start trading one month ahead of the reporting dates.
“This enables investors to capture both the market anticipation of surprises as well as the direct price impact of surprises,” Li said.
Li and his team built a model that predicts earnings surprises and how these might influence stock prices. It uses a predictive machine-learning method called logistic regression to examine both earnings surprises and returns over the past 15 years.
The most important factors over time included:
- A company’s so-called standardized unexpected earnings, calculated as the actual earnings per share minus the mean estimate divided by the standard deviation of the estimate. There’s a strong serial correlation over the previous four quarters, Li found.
- Earnings surprises over the past two quarters, which tend to align with the third event.
- Stocks with high analyst ratings, which tend to beat expectations and rally strongly.
- The nine-week change of consensus stock recommendations; stocks that were recently upgraded tend to beat expectations and vice versa.
One thing Li doesn’t mention as a factor is earnings guidance and coincidentally, fewer companies are providing this to investors.
According to a FactSet reporton Monday, 98 companies on the S&P 500 had issued EPS guidance for the third quarter, on pace for the lowest number since Q1 2015.
This may be due to uncertainty surrounding US trade policy, FactSet said. In June, Berkshire Hathaway CEO Warren Buffett and JPMorgan CEO Jamie Dimon published an opedtelling companies to reduce or get rid of quarterly guidance.
As for the rest of the factors, most of which are based on historical trends, Li says Citi’s model has an average hit ratio of 67% for companies that outperform and 61% for those that underperform.
Below are some stocks that are buy-rated by Citi analysts, which the model forecasts will see positive surprises and returns: