How to play the US third quarter earnings season

THIS week is widely expected to be crunch time for the markets across the world as the third quarter earnings season kicks off in earnest in the US. With companies from across the board reporting &ndash; including big hitters like Goldman Sachs, Citigroup, IBM and General Electric &ndash; we will finally see whether the rally has been based on more than investor optimism. Spread betters this side of the Atlantic should be paying close attention to American companies&rsquo; figures. The second quarter earnings saw more than 70 per cent of S&amp;P 500 companies beat expectations &ndash; compared to the historic average of 61 per cent of firms beating expectations. The exceptional results boosted equities so that, despite mediocre economic data, both the S&amp;P 500 and the Dow Jones Industrial Average gained 15 per cent on the previous quarter during the three months to September.<br /><br />Expectations are running high for this quarter&rsquo;s results, so companies will have to produce a solid balance sheet if their share price is to avoid tanking. Analysts were sceptical of the second quarter earnings figures, arguing that they were based on heavy cost cutting rather than any revenue growth. With companies as lean as they can go, we&rsquo;ll now see whether profits are being boosted by bottom line revenue growth. <br /><br /><strong>CHALLENGING OUTLOOK<br /></strong>Many firms are still struggling and those that depend on consumption will be especially vulnerable as rising unemployment and increasing fuel costs are likely to dampen consumer confidence further. Spread betters should therefore pay equal attention to firms&rsquo; outlooks, which are likely to have just as much effect on share prices as the figures themselves. Indeed, we have already seen J Sainsbury disappoint the market and reiterate that the outlook remains challenging.<br /><br />Spread betters should note that it normally takes around five years for earnings to double from a recession low, according to David Rosenberg at wealth manager Gluskin Sheff. &ldquo;It could be longer this time around given the lack of top-line pricing power in this deflationary cycle. Indeed, according to S&amp;P, revenues are set to decline 14.4 per cent year-on-year in the third quarter and that would represent an unprecedented fourth double-digit decline in a row.&rdquo;&nbsp; <br /><br />What&rsquo;s more, Rosenberg argues that US equities are over-valued at current levels at this stage of the cycle &ndash; the trailing price-earnings (p/e) ratio is currently 27.6 &ndash; and this will exacerbate any downturn as a result of disappointing earnings. &ldquo;Historically, when the economy is taking the turn away from contraction towards expansion, which indeed was the case in the third quarter, the trailing p/e multiple is 15 times, or half what it is today,&rdquo; he says.<br /><br />So with the earnings season likely to throw up more than a few surprises, these next few weeks could well set the course for global equities over the coming months. How should spread betters look to play the markets during the reporting season?<br /><br />If you think the majority of companies will come in above expectations then you could look to take a strategic long on the index or specific stocks or sectors if you are more confident in your predictions, in the hope that decent data will fuel the indices even higher. And what happens in the US market will certainly have a knock-on effect here in the UK, even before the London-listed companies start reporting. <br /><br />However, with many analysts wary of calling a definitive end to this recession, this could be a risky strategy, because if firms fail to match expectations then we could see a correction to the downside. In this scenario you&rsquo;ll be best positioned with a short trade on an index, says Angus Campbell, head of sales at spread betting-provider Capital Spreads.<br /><br />He says: &ldquo;If that is your view then you may be best selling the FTSE 250 as opposed to the main index, which is heavily weighted in miners and which is being propped up by their strength at this moment in time.&rdquo; <br /><br />However, Campbell notes that by going short you will be betting against the trend, so having a stop loss is probably prudent. &ldquo;Since we are near the highs and resistance is not far away, then a stop just above these levels might be the best place,&rdquo; he says.<br /><br />Philip Gillett at IGIndex recommends reviewing your stops and limit orders on open positions a few days before the earnings are released. &ldquo;Make sure that they&rsquo;re a suitable distance away to ensure you don&rsquo;t get stopped out because of short term volatility, although don&rsquo;t leave yourself overexposed either,&rdquo; he says.<br />Day traders may look to trade the spikes in individual stocks as companies report. However, this risky tactic will only work if companies significantly miss or beat the consensus forecast and/or alter their outlook as investors rush to price in the new information. If the results are in line with expectations and trading forecasts remain unchanged then you are unlikely to see any sharp move in the stock. <br /><br />The only thing we can be sure of is that we are soon going to know whether the bears of bulls have been right over the past few months.