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In the Game of Intellect vs. The Market, The Market Always Wins

Nicole Urken, Mad Money Research Director

From: Nicole Urken
Sent: Thursday, April 19, 2012 6:47 AM
To: James Cramer
Subject: Earnings last night

FFIV, KMP, QCOM, AXP, EBAY, VMW conference call transcripts attached. Going thru and sending round-up notes.

From: James Cramer
Sent: Thursday, April 19, 2012 6:48 AM
To: Nicole Urken
Subject: RE: Earnings last night

Thank you!


The above email exchange is merely logistical. But it represents the sheer volume of pages that must be read through — conference call transcripts along with research reports — to understand the quarterly reports of the companies during this first quarter of 2012. And the six tickers in the email above were just a portion of the companies that held their conference calls on Wednesday after the close. The flurry of news and reports during earnings season leaves even the most grizzled of veterans with a pounding headache — Jim Cramer has noted that he loses one pound per day during this flood of data (reading the Chipotle conference call accumulates less calories than eating Chipotle burritos in the end).

On "Mad Money," we have consistently reiterated that it is crucial always to use earnings season as a key period to collect data to identify the stocks whose sell-offs present opportunities and the stocks that sell off for good reason and should be left where they are — with at least a 6 foot poll between you and temptation to buy it up.

One of the many lessons I have learned from Cramer along with Stephanie Link, who co-runs the Action Alerts Charitable Trust, is that achieving outsized performance is not only about understanding the fundamental stories of individual stocks — it is also about understanding the temperament of market reactions. So far this earnings season, 245 companies have reported their quarterly results. According to Bespoke, 72 percent of companies have beaten earnings estimates while 70 percent have beaten revenue estimates. Plus, 7.4 percent of companies raised guidance this season versus just 4 percent that have lowered guidance. So, very strong overall to say the least. But this doesn’t tell the full story about how the stocks will act.

Take IBM , for example. IBM is one of the best positioned tech companies in the current environment, with a strong five-year plan that has focused on earnings growth acceleration — along with returning cash to shareholders — even amidst tepid revenue growth. The early transformation away from PCs, with a doubling down on software, services and analytics, has allowed the stock to become the angelic picture of forward-thinking that has contrasted with Hewlett Packard’s backwardness and lack of plan. However, even though the company raised earnings guidance in its quarterly report this week, the stock sold off. Why? There isn’t some complex intellectual reason. Largely, the sell-off was simply because of high expectations and a run-up into the quarter.

Other stocks that similarly saw a sell-off after solid numbers? The high-growth quick-serve names Yum Brands and Chipotle. Contrast this with McDonald’s , where expectations were dampened after last month’s same-store sales that were perceived to be “weak” — an overdone punishment reaction that allowed the company to benefit from solid results on Friday.

The law of great (or not so great) expectations cannot be underestimated, with names like Peabody gaining after beating numbers given much-reduced expectations and a stock that is off over 50 percent in the last year. (Read: Just because Peabody went up right after its quarterly report this week doesn’t necessarily mean the quarter was strong).

When looking at run-ups into quarterly reports, it is also key to be aware which names may have gotten caught in the cross-hairs of momentum-based hedge funds. EMC has long been a lower-multiple, more under-the-radar way to play the cloud theme of high-flier VMWare — given EMC’s has a majority stake in VMW. However, running into the quarter, EMC had outperformed, causing its solid results to be greeted with a sell-off. Similarly, Stanley Black & Decker was the less popular way to play the bottoming in housing — away from the popular homebuilders like Toll Brothers and the retail go-to favorites Home Depot and Lowe’s . However, more investors — including hedge funds — coming into the name (fueling its run into the quarter) set it up for bad tape once it reported.

The bottom line: Momentum is more than a physics term. It can burn you in the market if you don’t pay heed to stocks that have run. Even if your fundamentals analysis is right and a company reports solid results, the market always wins. That’s one of the reasons why the market is so brutal. If a money manager underperforms his or her benchmark or if you lose money in your personal account, “the market is wrong” is insufficient consolation. In the end, the market is right because that’s where the money is. No one cares about the intellectual justification. So don’t get caught in the river. Think about the fundamentals but also about the likely market response scenarios.



"Inside the Madness" appears twice a week at madmoney.cnbc.com

Follow Nicole Urken on Twitter @nicoleurken

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