STRATEGIES

Technical tools like Fibonacci, relative performance, and on-balance volume analysis can often fire early warning signals and keep stock investors safe from earnings-inspired meltdowns.

Corporate earnings season is generally a stressful time for investors and traders. Those holding company stocks before the earnings are released have to decide whether to take any action or simply stay with their long positions. Others try to determine whether they can earn a profit by buying a particular stock ahead of the company’s report.

Many have told me how they almost sold before a report, but ultimately didn’t, only to have their stock open sharply lower. Some also get convinced by a good fundamental story that the stock is turning around and they buy just before the report. If they fail to have a stop in place, they are then faced with another tough decision. Too many are either afraid to sell, or even worse, they lower their stop and ultimately end up with a larger loss.

There are three technical tools that I have found to be useful in warning that an upcoming earnings report may disappoint investors and that the stock could come under heavy selling pressure. Generally, at least two of these tools will warn you in advance that the outlook for a stock has weakened and that it is more likely to drop in reaction to the earnings report.

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One tech stock that has disappointed investors frequently in the past two years has been Cisco Systems Inc. (CSCO). The pattern of earnings misses started in August 2010 when the company reported a 79% increase in earnings, but the sales numbers were lower than expected. The stock dropped 9% after the report, and by the end of the month (point 2), it was 17.5% lower.

For the next few months, CSCO was helped by positive spin from some fundamental analysts and rallied back to a high of $24.60 (point 3). This was just below August’s pre-earnings high of $24.87. More importantly, the rally in CSCO stopped just short of the 61.8% Fibonacci retracement resistance, as calculated from the April 2010 high (point 1)¬†and the August low (point 2).

Fibonacci retracement analysis can be a very helpful tool for analyzing a stock ahead of an earnings report. If the stock has rallied but failed below the 50% or 61.8% retracement resistance, it gives little reason to initiate new buying. For those who are already long, the failure to move through a key retracement level is a sign that the stock has lost upward momentum.

The relative performance, or RS analysis, is often quite helpful because for stocks in well-defined downtrends, it would indicate the stock is weaker than the S&P 500 and therefore more vulnerable to selling pressure while those who are already long grow more disappointed by the underperformance.

The daily relative performance for CSCO had been in a downtrend since June 2010, as it had formed lower highs, line a, and lower lows, line b. The downtrend had been reinforced by the drop in August. The RS line was able to hold above its weighted moving average (WMA) until after the report was released.

CSCO closed on November 10, 2010 near the day’s high at $24.49 and opened the following day at $20.46 in reaction to the earnings report. This was a drop of 16.5%.

The on-balance volume (OBV) is the third tool that I find very useful, as it often leads prices lower and can reveal deterioration before the stock price drops. In the case of CSCO, the on-balance volume had broken an eight-month uptrend, line c, in June and had been in a shallow uptrend since the August lows. The August spike in volume was doubled in November when 553 million shares were traded. The negative impact of this heavy selling takes some time to overcome.

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Tickers Mentioned: Tickers: CSCO, ORCL, BBY, HPQ, AAPL