Capitulation… Again??


December 6, 2012 (9:45 am)

What Happened

For those of you who watch the market, you probably know already that Apple had it’s worst daily decline since the bankruptcy of Lehman Brothers in 2008. There were rumors flying around trying to explain the sell-off. Some say it was caused by an AT&T investor conference, where they discussed the fact that they sold a million more phones in October/November than they did last year. This was seen as a disappointment by some. What they fail to take into account, though, is the fact that Apple is selling its phones (or will be within the next 10 days) to over 100 countries and 250+ carriers. Last year, Apple’s carrier partners didn’t even come close to those numbers. Others say it was a digitimes article indicating weak demand.

In my view, it was predicated on two factors. First, the shares attempted – and failed – to break above $594 on three occasions. After three failed attempts, a slight pullback is expected. That’s what we saw on Tuesday, with shares falling from $594 to $575. That’s a healthy pullback to give the shares some room to make another run. What happened next – and the main cause of the massive and vertical drop – was essentially a margin call. COR Clearing, a significant institutional clearing house for medium- and larger-funds (think of e*trade, but for larger institutions instead of retail clients) announced that they would be raising margin requirements on Apple shares from $0.30 to $0.60. That means that, previously, their clients could post only $0.30 for each $1.00 of Apple shares they purchased. The announcement yesterday morning meant that those funds would now have to post $0.60 per $1.00 of Apple shares purchased.

Funds have two options when it comes to an increase in margin requirements. They can either post additional cash or they can sell shares until they meet the new requirement. By posting additional collateral (i.e. cash), they are essentially allocating a larger portion of the fund to Apple. Most wouldn’t choose to do that. They’ve already decided the exposure they want, and will stick to that plan. So they had to sell shares. The primary problem here, is that COR Clearing gave them until last night to do so. So what you saw yesterday morning was a situation where the number of sellers clearly overwhelmed any buyers, sending the shares spiraling down.

There was a rush for the doors, and the price needed to drop to compensate. But what you saw yesterday was a clear liquidation – almost like a run on the bank. I learned this morning that many clients of COR Clearing are market makers. Ugh. The market makers, who should have been buying into the weakness, were themselves forced to sell shares. And down it goes…

What Now

On the far right of the chart below, you can see where we are now. If you compare the RSI level to other points during the Sept-Nov sell-off, you can see that these very oversold levels tend to precede a rally of at least $20. The difference now, in my view, is that we broke the initial downtrend last week. So instead of the next “dead cat bounce”, as they’re called during corrections, we could see more sustained buying pressure.

More importantly, you can see that the additional selling pressure this morning can be viewed as a re-test of the November 16 lows. Most corrections don’t end in a V recovery, where the shares simply stop moving down and reverse into a large rally. Instead, you see a re-test of the lows, creating either a higher low or a lower low. This morning’s action, and subsequent small rebound, can potentially be viewed as a re-test and double bottom reversal. If we’re able to catch a bid here and buying pressure does increase, I believe that’s exactly what we have in store. You can see that the lowest levels from this morning’s sell off tested, and was rejected at, significant support at $522. That support held strong during the May correction, was only broken for four hours during the capitulation two weeks ago, and seems to have held this morning.

Lastly, I’m going to bring up this chart again. It’s fast becoming my favorite chart of all time. You can see that this morning’s sell-off again tested the lower trend line. It was, again, rejected and found immediate support at that level. Looking back to February 2010 and December 2011, you can see similar action. In both cases – along with the current action – you can clearly see a low, subsequent bounce, and a re-test of that low. That re-test creates a higher low, which also tests the lower trend line. Following this price action, you see the shares skyrocket. In February 2010, the re-test low was put in at $190. One month later, it was sitting at $240 (27% gain), before finally topping out at $275 (45% gain). Last December, the shares re-test the lows at $363. One month later, it was sitting at $425 (17% gain), before finally topping out at $644 (77% gain).

Mr. Market

While there are obvious reasons to be very pessimistic, I remain convinced that 2013 will be a very good year for Apple. The uncertainty around earnings growth seems to be worse than having certainty there will be no growth. Look at the P/E of companies with a zero growth story. Microsoft is trading at 14.5x P/E and analysts expect little growth there. I could not tell you why the market believes little to no future growth deserves a 14.5x P/E, but uncertainty of little to potentially significant growth deserves a 12.0x P/E.

I’ll end this by saying that this re-test of the lows has driven the Apple investor community mad. I’ve seen countless investors – who are otherwise smart, patient, and well-disciplined investors – capitulate late yesterday afternoon and this morning. Who knows… I may be the village idiot here. But if I was Mr. Market (as Buffett describes it), doesn’t this story sound too good to be true? Mr. Market can step in here, buy all the shares from those terrified retail investors near the lows, and ride the next wave back up? We still have six weeks until January earnings. I still expect big things.