How the Zacks Rank Predicts Price Movement
The Zacks Ranks does not influence price movement, it simply alerts investors to changes in expectations that may result in price movement. To better understand how the Zacks Rank can identify stocks likely to experience price movements in the next 1-3 months, consider the imaginary company XYZ Corporation.
Step 1: Brokerage Analysts Upwardly Revise Earnings Estimates
Analysts sense positive momentum in XYZ's business. Perhaps the analysts saw bullish trends in the latest earnings report or perhaps the company's management was unusually upbeat in a recent meeting. Regardless of the reason, the analysts are convinced that earnings in future quarters are going to be higher than they previously anticipated. As a result, the analysts issue new reports with upwardly revised profit expectations. This new information is sent to institutional investors, individual brokerage clients, and to Zacks.
Step 2: Daily Updating of the Zacks Rank - Your Personal Signal
Every night, the Zacks Rank is recalculated for the entire universe of stocks covered by analysts. A value is assigned to every stock based on the scores of the four factors described above and a new rank is assigned. This process takes into account the upward revision in XYZ's earnings expectations and, as a result, XYZ is assigned a #1 Rank.
Step 3: Institutional Money Starts Flowing into the Stock
Institutional investors (mutual funds, pension plans, money managers, etc.) have the greatest buying power to influence a stock's price. Most of these institutional investors employ valuation models that use earnings estimates as a prime component. Thus, when they receive new research from the sell-side brokerage analysts stating that EPS estimates are going up for XYZ, their opinion of XYZ improves. (The higher earnings estimate makes the stock appear to be more of a bargain). As result, institutional investors want to purchase more shares of XYZ for their portfolios. However, since they have so much money to spend and do not want to run up the price on themselves, they end up accumulating shares over the coming weeks and months. This can give the individual investor time to sneak in ahead of the institutions to reap the rewards of the rising share price.
Step 4: Momentum & Technical Analysis Investors Buy
There is a vast legion of investors who employ charting and quantitative models that look for trends like a rising share price and a corresponding increase in daily trading activity to spot winning stocks. In general, they believe that a stock on the rise will continue its ascent over the short-term. Therefore, given the impetus in the stock price and volume from the institutional investors in Step 3, these momentum and technical analysis investors may jump on board XYZ for a short-term profit and drive the price even further.
Step 5: Earnings Surprise
Nothing catapults a stock faster than a strong earnings surprise and the Zacks #1 Rank helps to identify those stocks that are most likely to issue a positive earnings surprise. The reason is that two of the four factors used in the Zacks Rank look for stocks with the strongest potential to post a positive earnings surprise (Upside and Surprise). In the case of XYZ, a very bullish earnings report could send the stock''s price even higher.
Step 6: Rinse and Repeat
If indeed XYZ Corporation posted an upside earnings surprise and gave solid guidance for the future, then it is very likely that this positive cycle will start all over again at Step 1. This "earnings momentum" effect is how the short-term benefits of the Zacks Rank begins to carry over into a major benefit for long-term investors.
"Most of the stocks I bought as ones or twos I''m still holding." Jerome ''Skip'' Garrison
Cadiz, KY
Negative Earnings Revisions
If earnings estimates are declining, a six step process resulting in potential downward price movement occurs:
- 1. An analyst senses negative business momentum and lowers his estimates.
- 2. A Zacks Rank of #4 or #5 is assigned, alerting investors, such as yourself, that earnings estimates are declining.
- 3. Institutional investors enter in the new information into their valuation models and view the stock as being less attractive. As a result, they sell their shares.
- 4. Active traders, who rely on technical analysis, notice the weakness in the price and sell the stock short.
- 5. The company issues a disappointing earnings report, causing even more investors to sell the stock.
- 6. If the company provides more bearish information, analysts lower their forecasts, restarting the process again.
Next: Price Spikes & the Zacks Rank
Previous: Zacks Rank Performance
Zacks Rank Guide Table of Contents
(A version of this guide formatted for printing is also available.)
