Why Do Stocks Go Down When Earnings Are Up?

By TradeSmith Editorial Staff

Last Thursday, one of the most important and successful companies in the post-COVID economy reported earnings.

FedEx Corp. (FDX) has thrived due to surging e-commerce demand, handily beating earnings expectations. For its fiscal fourth quarter, FDX earned $1.87 per share. That topped Wall Street analysts’ expectations by a penny.

On revenue, FedEx came in at $22.6 billion. That figure represented a staggering 30% increase in bottom-line revenue from the same time in 2020.

Even more remarkable, that revenue number topped expectations by more than $1.1 billion.

Ahead of the earnings report (on Thursday), FedEx stock pushed higher and higher. It hovered just above $304 per share during the last 30 minutes of trading that day.

After the bell and after FedEx’s blockbuster numbers, however, shares of FedEx plunged.

What gives? This company just reported incredible numbers… yet the stock fell. FedEx isn’t alone in this phenomenon. Today, I want to explain why a stock like FedEx’s falls despite positive earnings.

What Happened with FedEx?

FedEx’s earnings and revenue numbers were great.

But earnings numbers aren’t the only thing that investors and analysts are watching during an earnings report.

There are several essential things to consider. Earnings and revenue are backward-looking. Forecasts are forward-looking.

In the case of FedEx, the company released a few eye-popping warnings that raised red flags about the future. First, the company said it faced a significant rise in costs to address the rising demand for its services. One of the highest is the cost of labor, which has exploded as the economy reopens.

I’ve discussed the ongoing shortage of workers in the U.S. economy. Companies like FedEx are fortunate enough to have ample resources to pay new and existing employees more money (compared to smaller mom-and-pop businesses that don’t have ample finances).

FedEx said that its total operating expenses – the money they use to fund current business practices – increased by 23% year over year.

Simply put, the company was saying that the cost of doing business was going up. And when that happens, rising costs cut into profit margins.

When profit margins fall, investors might have lower confidence in the ability of the company’s stock to continue rising. In addition, lower profit margins can impact cash on hand and dividends. Higher profits will help generate stock buybacks and higher prices. Lower profit margins (or even negative profit margins) can do the opposite.

Pay Close Attention to Guidance

If you’re looking for an illustration of how guidance affects a stock price, let me show you one of the most famous examples.

In July 2018, Facebook (FB) reported earnings. Investors were greatly interested in the future of the company. Facebook was coming off the heels of a major scandal involving Cambridge Analytica over user privacy during the previous presidential election.

During that report, the company issued some incredible numbers. It reported $5.12 billion in net income or $1.74 per share. That beat Wall Street expectations, and it was a massive jump from the $3.89 billion (or $1.32 per share) reported during the year prior.

On revenue, Facebook reported $13.09 billion in sales for the quarter. That figure was a 41.9% increase from the previous year. However, even though the social media giant reported this huge increase, it wasn’t enough for investors.

Based on the stock’s rising price in the weeks ahead of that earnings report, investors expected Facebook to “crush” expectations.

The revenue growth percentage was lower than periods in the past, but the company also warned that this revenue growth would likely slow down in the future.

Within hours of that report, shares of Facebook fell by almost 20%.

The headlines said that Facebook issued “nightmare” guidance by suggesting that user growth would slow down, challenges in advertising would persist, and that expenses would continue to rise.

The selloff is linked to two factors. First, some investors had lost confidence in Facebook’s forward growth prospects.

Second, a lot of investors took gains off the table.

Buy the Rumor, Sell the Fact

One of the other elements that investors must consider is that many traders take profits from trades based on earnings. “Profit-taking” is very common around earnings season. If a company reports strong earnings, a trader might sell before other people can consider selling themselves.

There is a behavioral component to this that everyone must consider. If a trader believes that others will sell and lock in profits based on good news, they will move to sell the stock before others can.

The thinking here is that if the stock drops, the trader can simply repurchase it later at a lower price. If it doesn’t fall, the trader can just take the profits and move on to the next idea.

Longer-term investors shouldn’t be too overly concerned by earnings reports unless the stock falls sharply enough that it triggers a trailing stop. At that point, investors can wait for momentum to return to the stock and step in to purchase it.

However, any investor who struggled with a decision after Facebook’s “nightmare” guidance in 2018 could have used TradeSmith’s guidance. TradeSmith users would have known to sell when the stock entered the Health Indicator Red Zone on July 26, 2018 and wait for a new entry signal, which triggered on March 5, 2019. Shares of Facebook stock are up more than 100% since that time.

The takeaway here is: Keep calm.

I’ll be back to talk about one of the most impressive statistics about Google that you’ll ever see. If you think Google is an incredible company, wait until I show you a more innovative company with far more returns for investors since its 2004 IPO.