Chris Johnson and Jon Lewis

The Key to Finding the Right Stock to Trade -- Plus 6 Earning Plays

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In one case, the sentiment may have been excessively bullish heading into the event, which creates high expectations of a blowout report (ever heard of the earnings "whisper number?"). This also creates what is called a "crowded trade," which leaves little money to flow into the stock after the earnings release, no matter how positive the report.

On the other hand, there could have been a build-up of put options in anticipation that earnings might be missed. In this case, the expectation bar is set so low that meeting earnings projections is considered a positive for the stock. The result is that cash that was withheld from the stock based on pre-earnings pessimism pours into the market, pushing up demand and the share price.

This example points out a feature of using sentiment that some find intuitively difficult to grasp. A stock with relatively low expectations (pessimism) stands a good chance of rallying, as there is plenty of sideline cash available to boost the price.

Conversely, high expectations (the crowded trade) can put downward pressure on a stock, as there is little to no sideline cash to drive the price higher. In fact, the path of least resistance for cash is to flow out of the stock, resulting in declining prices.

Going Against the Crowd

So where do fundamentals and technicals fit in our behavioral valuation approach?

We've established the concept that pessimism can be beneficial (note that we did not say "is always beneficial") for a stock or sector, while optimism can be damaging. In other words, sentiment can be a contrary indicator. And the power of sentiment is much greater when it runs counter to the direction of the stock (pessimism during an uptrend, optimism during a downtrend).

For example, one would naturally expect pessimism for a sector that is trending lower. So sentiment isn't helping us find an edge. But what about pessimism during an uptrend?