Trading with Discipline


January 1, 2013 (9:30 pm)

Happy New Year! We have a lot of exciting ideas for Three28Capital that we’ll be implementing over the coming weeks and months. To start the new year, we’re introducing a new Multi-Strategy Portfolio. This portfolio will seek to take advantage of clear-cut, actionable chart patterns and technical indicators across 30 companies (including Apple) that we closely follow. We expect to supplement long or short positions with options to maximize potential gains while limiting risk. You can find details in the “Portfolios” drop-down menu.

Disciplined Trading (and Why We’re Comfortable Sitting on the Sidelines)

The SPY rallied almost $3.00 from its lows on Monday on expectations for a positive outcome from the fiscal cliff talks. We posted the chart below on Sunday night, expecting a short-term rebound to clear the oversold conditions before continuing down to re-test the November lows. We called the rebound almost perfectly, but did not participate. However, since the first leg down was strong, we still expect a second leg down on a failed re-test of the recent highs. We will position the SPY Portfolio accordingly.

SPY Push Up

To start the day on Monday, the SPY dropped to $139.50. That level has represented very significant support/resistance for many months, which can be seen on the chart below. On the successful test and quick rebound of that support level, we were very close to purchasing 3,500 SPY shares (roughly half the portfolio) at $139.60. But we didn’t. The SPY has presented a number of excellent clear-cut opportunities (both long and short) recently, each with multiple indicators pointing in the same direction. We’ve taken advantage of those opportunities and, over the past 9 weeks, are outperforming the SPY and QQQ by 6.0% and 7.6%, respectively. The issue here was that the shares were not yet oversold. Over the past three months, the RSI has dropped into deeply oversold levels on six occasions. Each of those instances preceded significant rebounds. The reason we chose not to take a position is that the shares could have gone either way on Monday. The markets were held hostage by rumors and speculation about the eventual outcome of the fiscal cliff discussions. Had the talks disintegrated, there was a lot of room to the downside before oversold conditions created support.

SPY Channel

What Volatility Tells Us

On Sunday, we included the following VIX chart and presented evidence for a near-term rebound. First, the VIX was overbought on the RSI. This buy signal has preceded a rebound in 9 of the last 11 cases. Second, the VIX closed above its upper Bollinger Band several days in a row. This price action also tends to precede a near-term rally. Both of these signals correctly called this rally.

VIX

So why do we still expect a second leg down to re-test the November lows? The VIX shot up to the low 20’s on Monday morning – a level not seen since the summer. Volatility correlates with the uncertainty in the markets. It’s clear that this uncertainty revolves around the fact that our politicians are having extreme difficulty getting anything of substance resolved. I wouldn’t be surprised if the current market action reflects a buy the rumor, sell the news mentality. After all, market participants understand that even if there is a successful outcome on the fiscal cliff legislation in the coming days, we’re very likely to see a repeat of the 2011 debt ceiling fiasco in less than two months.

The Apple Rocket

And then there’s Apple. On Monday we finally saw the shares breakout from the downward sloping trend line that has acted as strong resistance during almost the entire sell-off. While we saw a false breakout in late November, very rarely do shares have more than one false break in a given direction.

AAPL Trend Lines

Apple is now nearing overbought territory on the 60 minute charts. When the current market rebound fails, which is still our current expectation, Apple will very likely re-test this trend line. Since the trend line has so many touches, it should act as significant support.

Double Bottoms and a Potential Double Top

We’ve previously commented on the large potential double bottom (green lines). This pattern formed from $503 (the average of the bottoms) to $594 (the high). This gives us a $685 price target. If the W-bottom remains fairly consistent, we could see that price target by early February. But I would not take any positions based on that. It’s simply a possibility.

There are two smaller, conflicting reversal patterns in play. The first is a potential double bottom (blue lines) that formed over the last two weeks with the $501 low and the $505 re-test. That pattern has a $565 price target. However, we ended Monday’s trading session right at the recent highs. If the markets turn over tomorrow and begin to sell-off, this re-test of the highs would look awfully like a double top (with a $473 price target). It’s unlikely that the price target gets hit, however. More likely would be a test of the downward trend line. The market has successfully rejected the very low $500’s on several occasions. With the tax selling coming to an end, and a high number of funds looking to increase allocations to Apple in the new year, it would be a surprise to see a sharp sell-off in shares even if the broader market gets ugly.

AAPL Double Bottom

Long-Term Trend in Tact

The near-term price action in Apple is very challenging to forecast. What’s much easier is the long-term trend. Lou Gennarell, a friend and fellow Apple investor (you can trust him, he’s a doctor), provided the following chart. I hadn’t analyzed the charts in the same way, and think his analysis provides a lot of support for our long-term fundamental thesis. As you can see, Apple found significant support and resistance at the major trend lines. The recent $501 bottom took place precisely at the lower trend line, which remains entirely intact.

AAPL Trend - LGennarell

How Long Will Extreme P/E Compression Last?

The last thought of the night revolves around Apple’s recent correction and its impact on the P/E range. The 13.0x-17.0x P/E range has remained fairly consistent since early 2011. Will the recent P/E compression down to the mid-11 level prove to be an aberration? Since even low growth tech stocks have a mid-teens P/E, this level is likely too low. Apple is now not only a moderate to high growth company, it is now a dividend payer. With a 2%+ dividend yield and very attractive valuation, early 2013 should see significant rotation into the name. While a P/E valuation in the high teens is less likely going forward based on the sheer size of the company, the 13.0x-15.0x range should represent “fair” value over the coming months. The market is currently valuing the uncertainty around Apple’s future growth prospects at a discount to even no-growth peers. Investors will look back at a mid-11’s P/E as an outstanding buy opportunity.AAPL PE