Tim Bovee, Private Trader: FB: In context

Facebook Inc. (FB) went public May 18, 2012 in one of the most anticipated and, in retrospect, most embarrassingly botched initial public offerings in recent memory.

It opened at $45 a share, sank to a low of $17.55 a share and then, a year after the IPO, began a steep rise that has carried it to $72.59 a share, from which heights it has retreated by about $10.

New stocks notoriously sink after they first go public, and then get their groove on and become normal stocks, responding to the ebb and flow of business and trader sentiment.

So it is with FB after two years of trading.

But even two years of history presents chart analysts with a problem: Where does the story begin? When FB or any stock parachutes into the markets, it already has a history, albeit a secret one. When it lands on the trading floor, it is in a context, of its sector and of the business cycle.

So FB presents a classic case of the middle-of-the-opera problem: I was late to the opera and seated at the start of the second act; what can I infer about the first act based on what I see and hear. I need something on the stage to put the action in context. Enter Google, stage left.

Facebook as a business is in many ways an analog of Google Inc. (GOOG). Sure, they differ in that GOOG is serving up searches (plus many other things) and FB is providing a platform for online discussion.

But in essence, they're in the same business of using fundamental Internet activities -- search and discussion -- to provide an audience for advertising.

The Charts

Below are two charts, GOOG on the left and FB on the right. I've set the width of the FB so chart so that it the passage time matches that on the GOOG chart. FB's IPO is marked by a red line on the GOOG chart.

I've imposed an Elliott wave frame on both, using the GOOG count, with its longer history, to suggest a starting point for the FB count.

Click on chart to enlarge.

GOOG 5 years 7 months 2-day bars (left), FB 2 years 2-day bars

When FB went public, GOOG had just completed correction, which I've labeled as wave 2 {+4}. It was a triangle, which normally appears in 4th waves, but the count begins with the Great Recession, as nearly all stock chart analysis must.

Using that frame, FB's initial decline after its IPO can be seen as a portion of the truncated "e" leg of the triangle that ended wave 2 {+4}.

There's a time lag. GOOG completed that decline in June 2012, and FB reached its low in September 2012. I can interpret it as FB playing catch up, although more likely it is a combination of the normal short-term speculation in IPOs and a response to the technical problems at the exchanges that stopped some orders from going through.

In any case, both charts match nicely once wave 3 {+4} to the upside has begun. The Elliott wave count shows them both in a 4th wave correction at the {+3} degree, and once that is done, they will each rise to complete wave 3 {+4}.

Overpriced?

Is Facebook overpriced? Not according to the chart. A correction is often a set up for a profit opportunity. Besides, in Elliott, the whole question of overpriced or underpriced is irrelevant. If a stock is in a mature 5th wave to the upside, then a correction probably lies ahead. If it is in a correction within an uptrend, then the future holds a further rise.

But there are other ways of looking at the question. For example, applying earnings growth estimates to FB's price allows me to impute a "fair" price for FB.

The calculations show that growth estimates imply that FB's "fair' price is $37.84, meaning that the stock is overpriced by 67%. I've marked that price on the FB chart in purple.

That is terrible terminology, of course. A "fair" price in the stock market is a meaningless concept. It's an open auction, and buyers and sellers continually reach agreement on a price that meets their assessment of what ownership of FB is worth in terms of the buyers' and sellers' own needs.

I've underlined that last part to emphasize that there is no pristine "fair" price hovering over Facebook headquarters in Menlo Park, California. One trader's fair price is another's damnable fraud.

That extra $25 in the price represents hope, buyers' expectations about FB's future. In itself it is not a barrier to opening a bull position in FB, as long as I judge that the company can meet those expectations.

Another method of judgement is to treat FB's earnings as equivalent to dividends on a bond. True, FB pays no dividends to shareholders. It retains them within the company. Presumably, those funds are being used to make the company grow and so they will show up as capital gains in a higher stock price.

Facebook's earnings yield is 0.79%, a very low level. Compare it to the benchmark 10-year U.S. Treasury note, which yields 2.48%. So, by this measure, FB is pricing in more than 200% worth of hope (2.48% being 214% higher than 0.79%).

FB is selling at 80 times earnings, a very large premium, and at nearly 20 times sales. Should a trader really be willing to pay $80.02 to control a dollar in earnings, or $18.22 to control a dollar in sales?

And then there are the options, whose pricing implies a certain trading range. It is usually expressed as one standard deviation from the current price, a range expected to contain 68.2% of trades. of course, that means that 31.8% of trades will be above or below that range.

Options are implying that 68.2% of FB trades will fall between $56.85 and $69.75 over the next month, for a potential gain or loss of 10.2%.

Over the next year, 68.2% of trades will fall between $40.96 and $85.64, for a potential gain or loss of 35.3%.

The "fair" price implied by earnings growth estimates is below even the one-year range, which means that options prices suggest that the "fair" price won't be seen between now and June 2015.

Finally, the FB chart has the stock in a sideways correction that, at its low point of $54.66, came close to hitting the 38.2% Fibonacci retracement level. That's about right as an ending level for a sideways correction.

Corrections have a tendency to reverse at Fibonacci levels, but it is a tendency not a rule.

Friday's close, $63.30, is 18% above the 38.2% retracement level, $53.61. It is possible in this correction that FB could again approach that level, or even fall below it a bit. By that measure, FB is overpriced by 18%.

Decision for My Account

None of now. I have FB on my Watchlist as a potential bull play under my longer-term rules. It's a company that dominates what is still a relatively new mass market, if group discussions are considered to be something separate from what Google does. And I do think that they're sufficiently distinguishable to allow Facebook to prosper in a niche of its own.

The immediate problem for me is to find the correct entry point so I can identify a clear move on the chart into an uptrend.

The first high set within the sideways correction, $63.91 on April 2 was exceeded on May 29, with a high of $64.30. However, the price retreated the next day. That's a good level that, when breached, tells me something interesting is happening.

My entry strategy for now will be to set a close above $63.91 as my bull signal and to require confirmation by a close above that level the next day. If both of those requirements are met, then I'll begin active Elliott wave tracking and open a position if wave 5 {+3} has begun. I've marked that level in blue on the FB chart.

-- Tim Bovee, Portland, Oregon, June 1, 2014

References

My shorter-term trading rules can be read here. My longer-term trading rules can be read here. And the classic Turtle Trading rules on which my rules are based can be read here.

I use the number 68.2% in using applied volatility to calculate the expected trading range. This comes from statistics and refers to the one standard deviation boundaries, which are expected to contain 68.2% of whatever is being studied. Putting it another way, given an item (a trade or whatever), there is a 68.2% chance that it will appear within those boundaries.

Elliott wave analysis tracks patterns in price movements. The principal practitioner of Elliott wave analysis is Robert Prechter at Elliott Wave International. His book, Elliott Wave Principle, is a must-read for people interested in this form of analysis, as is his most recent publication, Visual Guide to Elliott Wave Trading.

Several web sites summarize Elliott wave theory, among them, Investopedia, StockCharts and Wikipedia.

See my post "Chart Analysis: Nomenclature" for an explanation of my method for labeling waves on the chart.

By preference I place my shorter-term trades in the last half hour before the closing bell in New York. See my essay "When is the best time to trade" for a discussion of the practice.

Disclaimer

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.

No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decisions for his or her own account, and take responsibility for the consequences.