Corporate earnings-whether they are good or bad-are always dominating the financial news, so this would be a good time to dissect just what they are telling us as investors. One thing to keep in mind is that earnings are only part of the story because a lot of a stock's performance can be traced back to the sector in which it resides. Money flows into various parts of the economy at different times. This is why it is so important for investors seeking profits to always focus in being in the correct sector.

When companies issue earnings reports and estimate their future profits, management is assumed to have done their best to create an accurate picture of the current state of affairs and to have carefully mapped out the possibilities for the near term. Management then supplies this data to interested players, among them the big institutional investors. It is this group of people who often determine the direction of the market and the flow of money into and out of sectors.

Keep in mind when speaking about institutional investors that we are talking about the professional money managers who control the investment of trillions of dollars. This money can be pooled in hedge funds, mutual funds, and pension plans. In addition, these institutions employ analysts who study different type of financial models and they help
institutional investors decide what to buy and sell and as well as when.

Of course, the primary basis for these financial models that analysts use is the earnings report. They put together stock valuation models based on past earnings and, more importantly, they also project future performance. Stock valuation models from different analysts are not going to be the same; their future earnings estimates cover a range of predictions, from low to high.

Earnings per share is the number derived when you divide a company's net income by the shares of common stock outstanding. This figure is also the denominator in a very important ratio called the Price to Earnings ratio. The P/E ratio is what you get when you divide the stock's price by the latest 12 months of Earning per share, and it signifies the premium investors are willing to pay for each dollar worth of earnings. Typically, the lower the P/E, the cheaper a stock's price relative to earnings.

The executives at these publicly traded companies started to realize that, rather than run the risk of not meeting estimates, it was always better to lower expectations and then surpass them. The analysts perpetuate the trend by issuing their own conservative earnings estimates. This allows them to generate more buy recommendations to their clients than sell recommendations.

The usual pattern is that when an earnings estimate gets raised, a lot of investors pay attention. Those stocks are then likely to outperform the market. If it gets lowered, even more people pay attention and those stocks will more than likely underperform. This pattern will emerge once again after we lift ourselves out of the current economic turmoil. In the meantime concentrate on the best performing sectors using exchange traded funds and tread carefully when looking at any earnings surprises, especially on the upside.

Happy Trading.

Jeff Neal
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
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