What’s Behind Our Upside-Down Bizarro World?

It’s earnrnings season, and that means plenty of opportunities to make or lose money based on whether companies beat or miss expectations and how investors react to future guidance.

Normally, this is a good time to profit from solid research and preparation. Companies doing well tend to rise, and those that fall short tend to get taken to the woodshed. But something strange is happening this time around. It’s sort of like that alternrnative Bizarro World that Jerry Seinfeld referenced in the famous “man hands” episode.

Things are strangely the opposite of what they might seem. (Or, if you’re more up to speed on current television, we’re in the “upside down” world of Stranger Things.)

To be sure, there are companies that have missed earnrnings and seen their stocks get hit, like normal. But more and more, I see the opposite of what the fundamentals might imply.

Take Mastercard Inc. (NYSE: MA). The company exceeded both top- and bottom-line expectations. Business is booming globally. Management is solid and investing aggressively in its future.

The results were met with a thud.

The stock initially popped on its earnrnings report – only to sell off from there. By midday after the earnrnings report, the stock was in the red on high volume. Bizarre.

Mastercard is just one of many examples. At our Irrational Economic Summit in October, I highlighted Gilead Sciences Inc. (Nasdaq: GILD) as a stock to play from the long side for the next several earnrnings releases. The company reported shrinking sales and faces a tough Hepatitis C business. However, the recent acquisition of Kite Pharmaceuticals is a game-changer for the future of cancer therapies, Gilead is already a massive cash flow generator, and it has plenty of room to jack up the dividend.

And, still, the earnrnings release was also met with crickets, and the stock has drifted lower. Even more bizarre.

At IES I also warnrned that when, not if, Netflix Inc. (Nasdaq: NFLX) releases a whiff of bad news, the stock is in for a $20 to $40 decline from recent levels. However, Netflix reported subscriber growth that blew away estimates both domestically and internrnationally. This is the metric that investors have been focused on.

Management also seemingly navigated a price increase without too much trouble. Under normal circumstances, the expectations-topping growth in users would be met with euphoria and push the stock higher by at least 10%.

But guess what: Shares popped after a few hours only to deflate since then.

Are investors starting to sharpen their pencils and figure out that other metrics may matter more for Netflix’s future success than traditional benchmarks? Some of these factors I mentioned in Nashville include huge content liabilities, poor cash flow trends, weak earnrnings quality, and a premium valuation.

In each situation, the stock performed the exact opposite of what I might expect from analyzing the fundamentals.

What’s causing Bizarro World?

I have a few ideas.

First, there’s very little stock-picking done anymore that drives volume in the markets. Volume is now often being driven by computers looking to make a 10th of a penny off a transaction. High-frequency trading programs have exploded since the last crisis nearly 10 years ago.

Fundamentals don’t matter to computers. Small profits from trading stocks do.

Research from Credit Suisse suggests that as high-frequency trading has become more prevalent, investments in passive indexing strategies have exploded. How does this help cause Bizarro behavior? Because indexes are indiscriminate. They buy all the stocks in the index even if the fundamentals of a particular stock are a disaster.

That’s why you might see a stock down in the mornrning but then, as index rebalancing takes place near the close of the market, it’s almost as if a magic hand is lifting the share price.

Meanwhile, the share of volume from active managers has deteriorated. I’ve seen estimates that stock-picking accounts for only 10% of the market volume today. That skews stock behavior away from the rational to the unexplainable.

What could cause this behavior to change?

We need a healthy market correction. Typically, short-sellers would step in to buy and cover stocks in a declining market and book profits., But short-sellers have become a rare species in this unprecedented low-volatility bull market.

High-frequency trading programs may step to the side or exacerbate the downside, but in this low-volatility grind higher they’re not helpful to rational stock-pickers. Or index investors might get spooked, and money coming out of indexes might normalize the balance between passive and active managers.

This would help refresh the market and returnrn it to a more balanced position. Then we can leave this Bizarro World behind and finally get rewarded for good research.

Good investing,

John Del Vecchio

Editor, Hidden Profits

John Del Vecchio

Using his proprietary forensic analysis, John does all the hard work of digging, weeding out and analyzing the few rare stocks that most of the market has overlooked, but are set to pay out handsomely in the months and years to come.