How Events affect Perception and Investor Confidence

There are times when a company's earnings history and projections are the only solid data that you have on which to base a decision about its stock. Although that may be enough, you must nonetheless constantly monitor your stocks for events that can change either a company's market perception or investor confidence; because, as we learned in the article Why do Stock Prices Move?, these two factors are crucial to price changes and the valuation of every stock.

Let's take a look at just a few events that can change the perception of a stock's future earnings and the confidence level about those earnings. The different strategies that you may use in implementing your investment program should closely monitor these factors.

Earnings announcements. A company's quarterly earnings are the primary factor in altering market perception and investor confidence, although the direction of the change may not always be what's expected. For example, the just-announced earnings figures could actually be record-setting, but the market may have expected an even larger number, one based on 'whisper numbers' (which are those unofficial earnings estimates that are spoken of by brokers and analysts in phone calls and informal settings a week or two before a company's earnings announcement is released; although unofficial, these figures are the market's true expectations of the company's earnings). Consequently, what appears to be positive news is perceived as negative, and the stock price declines. A company's failure to meet its whisper numbers is often viewed as an early warning that future earnings and the accompanying expected growth rate might not be reached. However, if a company announces earnings that meet or exceed the market's expectations (especially if it has a history of doing so), the perception of a strong future along with investor confidence that it can be achieved can boost a stock to record levels.

Revising estimates. One of the most accurate forecasters of positive or negative moves in a stock's price is the one-month change in analysts' estimates. Generally speaking, the first research report written by an analyst is positive. This is due to the fact that, frequently, the analyst is performing his or her duty to the firm and looking for good things to say. A revision of those estimates, however, is quite meaningful because it requires a separate initiative by the analyst to admit that he or she was wrong or simply had a change of mind. An upward revision in earnings estimates will likely produce a positive change in the price of a stock. However, a downward revision will tend to have an even more dramatic effect on the stock price than an upward revision; in fact, it could be devastating. It takes a great deal of courage for an analyst to lower an estimate, because in many cases he or she is saying something negative about a client of the firm. Additionally, the number of analysts who make a revision is also highly significant. Several analysts raising or lowering their estimates will have a much greater impact on a stock than just one analyst issuing a revision.

Company warnings. When a company itself advises stockholders that it won't meet its next earnings estimates, the news should be taken very seriously. This kind of announcement automatically causes such a fall in the price of a stock that it's a safe bet the company is telling the truth. Therefore, company disclosures are one of the best ways of knowing what's likely to happen to future earnings.

Interest rate changes. The lowering of interest rates has two potential impacts on stocks, both generally thought to be positive. First, the prevailing sentiment is that lower interest rates give consumers more money to spend, which translates into higher profits for businesses, which in turn makes companies more willing to spend money on inventory, research, new products, and expansion – all of which stimulate the economy. Higher profits are expected to lead to increased earnings, so investors become more confident about the future earnings potential of companies in general. In this way, lower rates are intended to produce a positive ripple effect throughout the economy.

The second positive impact of lowering interest rates has nothing to do with market perception of future earnings or investor confidence at all. Lower rates simply make investors less likely to buy debt instruments (bonds) and more likely to buy equities (stocks), thereby driving up stock prices across the board.

Conversely, an increase in interest rates has precisely the opposite effect. Higher rates cut into business profits and act as a restraint on consumer and company spending, all of which work to slow down the economy. And higher interest rates siphon money out of the equity markets and direct it toward debt instruments.

Insider trading. If company insiders use their own money to buy stock on the open market, it's a pretty good sign that they believe their company's future earnings are going to be better than the market expects. At minimum, it indicates that they feel the company's stock price is too low at that time. And company insiders should know the company's prospects best (of course, insiders aren't always right).

On the other hand, insider selling, while not a good sign, may not necessarily be as bad as it first seems. Many companies base executive compensation programs on stock, which leaves insiders with no practical way of buying new homes or sending their children to college other than by selling their holdings. Furthermore, insiders often have only a few weeks each quarter in which to accomplish these transactions. This is to prevent them from trading on information that hasn't yet been released to the public. Having said that, insider selling generally does not imply confidence in a company's future; and if they're selling in large quantities, that's a very poor signal indeed.

Of course, the abovementioned events are only a very abbreviated list of factors that can affect market perceptions of future earnings or investors' confidence that earnings will be met. Regardless of the investment strategy or style that you employ, be aware that these issues must always be taken into account.

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