Earnings Estimates and the Acceleration of Acceleration
From 0-100 is a different game than from 100-200
O.k. yesterday was a good day, Port printed another ATH into the close.
As I have written, the tape is o.k., not blazing, it’s a stock pickers market, companies with good business developments get rewarded, stocks that do not deliver 100% get punished hard.
That brings me to the subject: Rate of change of earnings estimates and the rate of change and the second derivative of the rate of change of it.
I know that is a lot to swallow: ROC and the second derivative of ROC.
And as I have written, it took me decades to understand it. First the concept and then the why.
Have a look at Zoom and you see how important they are.
Why did the hell Zoom sell off yesterday (in a strong yesterday tape!)? Earnings estimates are still looking good (at first sight), they just went down a little yesterday. And why did the stock get not much, much higher on accelerating earnings estimates when they reported in November (second little orange spike in the following screenshot) and then drifted down from around January 2021 even when earnings estimates went up even further?
Have a look at the first earnings estimate point (first arrow above). It’s the perfect buy point because not only go earnings estimates up, the acceleration of the acceleration (e.g., the second derivative of it) was huge and price did not spike up much.
The next print (second arrow above) of the earnings estimate: they went up, but they went up less than the first print: e.g., earnings estimates still accelerated, but they accelerated less.
Compare it to a car. Let’s take the 911 Porsche Turbo S. It prints 2.8 seconds from 0-100 km/h.
And then takes ca. another 7 Seconds from 100-200 km/h. So, from 100-200 km/h it still accelerates, but the acceleration of the acceleration is less than from 0-100 km/h.
You want to buy a stock from 0-100 (lightning-fast acceleration) not from 100-200 (still fast acceleration but less then from 0-100).
Depending on the valuation of the stock (and Zoom is priced to perfection!), it would only go up if the acceleration from 100-200 km/h would be 2 Seconds (e.g., acceleration accelerating), not 7.
It would be another thing if it would not have been priced to perfection (that’s why a value component in a ranking system even for growth stocks works well, but that is another subject).
And now the big thing: You can transfer that counterintuitive logic to the overall market!!!
It does not matter if you measure and map the ROC of GDP, Inflation, Fed Policy or whatever.
As soon as you are at the point where from 100-200 and the acceleration of the acceleration is less then from 0-100 watch the hell out! (in macro terms: have a look at the 42Macro.com posts on twitter and you know what I am writing about).
Why is it so hard to get this? Because we are humans. And if you drive a 911 Porsche Turbo S the first 0-100 experience is so beautiful that a positive sentiment builds up and when you are at 100 you are so exited (as a ton of high beta momentum investors where in Jan 2021 with for example Zoom and a ton of other similar stocks) so you do not feel that from 100-200 the acceleration gets worse.
But smart traders sell into the 7 Seconds from 100-200 and would load up the boat even more if the car (stock) would even accelerate in 2 seconds from 100-200. Gravity kicks in hard from 100-200!
I know this is extremely hard to swallow and to me it felt even extremely unjust! My thinking was: hey Zoom is a great company, great technology, they change the world, they have a great management team. The thing is that is still all true, but a good company and a good stock are two different things.
The same now in the macro space: hey we are much better of then in March 2020 when Covid hit. How can it be that the stock market got so difficult from February 2021 on? Because pro investors knew, we start to slow into the second half of 2021, and they sold stocks hard that had a less good acceleration from 100-200.
When everything is blooming (0-100) you are simply happy that it is, and you are still fine with a little less acceleration from 100-200.
But that is not how markets work!
In my endeavor as a trader got much better when I started to let that sink in and getting a deep understanding about that concept. If you get this concept right and at the bottom at your brain and you heart your trading will get much better.
So how to implement it?
First of all, my best trading systems make sure I select a stock with good factor rankings: momentum, industry momentum, institutional ownership, quality, value are the big factors I have in my ranking systems.
Second, I filter for accelerating earnings estimates and I get the hell out as soon earnings estimates go down or crowding starts to kick in (crowding: a lot of people are long).
Let us have a look at the following screen from implemented on www.portfolio123.com
I like small cap and mid cap companies (for a reason, the market is less efficient in this space then in the big cap space) and they have less volume than big caps (in general).
So, I filter for it.
I exclude China and financial stocks (back test shows that’s good thing to do, lets leave it here for now).
Rank > 90: I then make sure the stock has a good rank on my factors (momentum, industry momentum, institutional ownership, quality, value).
And then I look for stocks that have improving earnings estimates.
Now let’s look at the stocks its selecting today and lets just look at CTHR (no recommendation, please make you own due diligence!):
See something? The estimates (orange line) exploded but the stock barely moved (that generally only happens in the small cap space which is a huge advantage for a trader with a sub 1 Million account). You got a ton of time to get into the stock since it did not gap up.
If you are a systematic trader and your systems pick it, you would simply buy it.
If you are a systematic trader and macro aware you would check the macro-outlook and put on a big position in a blazing reflation market and a smaller position in a shallow deflation market (even hedged with TLT).
If you are a systematic trader with a discretionary touch, you would do further due diligence on the stock (social trends etc.).
So, what’s my recommendation in this post?
1. Get your head and heart (!) around ROC and the second derivative of it (0-100, 100-200)
2. Have a good ranking system on you stocks weather you make it discretionary with a check list for example via
https://marketsmith.investors.com/
or www.portfolio123.com or you systemize completely
3. The kicker are earnings estimates (Phase 0-100 or 100-200). Have a look at them before you buy anything and sell into earnings estimates that are not so hot
4. Be macro / tape aware. A great stock with great factor rankings and great earnings estimates still can go down hard if everything goes down (let’s say a deep deflation with volatility trending).
There is one last thing about up earnings estimates revisions. You will not find much of them if the macro regime is really bad (deep deflation). That means, the less you find the more cash you will have in your portfolio, so you will be protected in a bad market.
Or you might find for example a ton of gold stocks getting great in a deep inflation regime, because of cause their earnings get up.
ROC EPS, Inflation, Policy = influence earnings estimates.
There you have it. Good luck out there and happy trading.