When bad results boost stocks

Posted Jul 23rd 2008 10:00AM by Peter Cohan
Filed under: Earnings Reports, Yahoo! (YHOO), Citigroup Inc. (C), Bank of America (BAC), Wachovia Corp (WB), Washington Mutual (WM)

It's officially a trend because it's happened more than three times -- a bad financial report leads to a spike in stock prices. (I posted here and here about this phenomenon with Citigroup (NYSE: C) and Bank of America (NYSE: BAC) respectively). Now, the New York Times reports that five banks lost billions, or saw their profits plunge, but their stock prices rose an average of 12.9% in the wake of those reports.

Why? The conventional wisdom suggests that investors expected them to do much worse and were pleasantly surprised. And this phenomenon is not confined to banks -- this morning, Yahoo (NASDAQ: YHOO), which reported a penny less profit per share than the 10 cents analysts had expected, is up 3% in premarket, reportedly because it did not lower its guidance.

I am not convinced by conventional wisdom about why these stocks are up. My hunch is that there were many traders who sold short the stocks of these companies because they expected them to do worse than they actually did. When reported results beat expectations, investors bought the stocks, perhaps due to bottom fishing. These buyers caused the stocks to rise enough to trigger margin calls for those who were short. The shorts bought to satisfy those margin requirements, causing a buying panic. I wish I had data to test this hypothesis.

Here are five examples:

Citigroup reports $2.5 billion loss -- expected loss was $3.67 billion -- stock rises 9.7%.
Bank of America reports 41% drop in EPS -- expected decline was 48% -- stock creeps up 3.8%.
Wachovia (NYSE: WB) declares $8.9 billion loss, stock soars 29%. This could have something to do with its announcement that it would not issue new shares that would dilute existing shareholders.
Washington Mutual (NYSE: WM) loses $3.3 billion, stock goes up 6.2% -- its loss of $3.34 a share was triple the $1.05 loss analysts had expected. I cannot even begin to explain why the stock rose.
SunTrust Banks (NYSE: STI) profit declines 21% -- expected decline was 66% -- stock increases 16%. This one makes some sense to me.

Does this mean that the bottom fishers are right? It's possible, but I doubt it. My hunch is that it will take more than another quarter or two to clear out all the problems from an $8 trillion loss of wealth in America resulting from the real estate market collapse. These recent upticks could be a classic bear market rally. If you are a short-term trader who jumped in last week, be prepared to take your profits.

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He owns Citigroup stock and has no financial interest in the other securities mentioned.

Tags: bac, bank of america, BankOfAmerica, c, citigroup, featured, sti, suntrust, wachovia, wachovia bank, WachoviaBank, washington mutual, washington mutual wm, WashingtonMutual, WashingtonMutualWm, wb, wm, yahoo, yhoo

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Reader Comments (Page 1 of 1)

7-23-2008 @ 10:24AM

william lindblad said...

I agree, a concept of "Bad being Good" does not make any sense - especially in the finance area. Now, if there is a way to convince everyone that the mortgage mess is "good", all problems are solved.

7-23-2008 @ 3:17PM

Sarah said...

This ought to get interesting in August when the FDIC releases its list of banks in financial trouble.

The economy is contracting. As Secretary Paulson said over the weekend, "There';s a lot more problems ahead and they won't be solved over just a few months."

Inflation continues to rise and the economy is slowing down...