Why does a stock’s price decline when earnings are good?

[Benjamin Schmitz]

[Steve Walters]

Investors are always looking for stocks with solid earnings since it shows the company is making good business decisions and increasing value for the investors. That’s why it is confusing when a company reports good earnings, but the stock price falls. Why does that happen?

Buy the Rumor, Sell the News

Buy the rumor, sell the news is an old saying in the financial markets. It means that often the value of a good earnings report is priced into the stock ahead of publication. Investors buy the stock ahead of the earnings result with expectations that the company will report better than expected profits. Once the news is out such investors decide it’s time to take their profits and the stock price falls.

Company Guidance

Just because a company beats its profit forecast in one quarter it doesn’t mean the business is doing great. That’s an error of judgment many beginning traders make. There are many cases where a company does well on earnings while also lowering their future guidance. This lowered future guidance scares investors, who will always fear the worst. In this case the investors often sell the stock to lock in their profits while the picture is bright, figuring the good times are over.

Hedge Fund Activity

Hedge funds often hold large positions they cannot unwind without impacting the share price. During earnings announcements the volume in a stock often explodes, and this gives hedge funds the opening they need to sell a large block of shares without significantly impacting the price. If the earnings were better than expected there are often plenty of buyers to keep prices high and that helps the hedge funds unwind their positions.

Panic Selling

This can occur when one of the three scenarios above is playing out. As investors take profits and a share price slides lower, there is a sense of fear and then panic. This leads to more selling, which sends the price rapidly lower. This is an example of how traders often make decisions based on their emotions. It doesn’t matter if the fundamental reason for buying the stock is still sound if the sight of your money disappearing puts a knot in your stomach.