Friday, February 1, 2013

GD: An impressive head fake

General Dynamics (GD)  soared after a downside earnings surprise, but traders who jumped on the band-wagon were in a for shock as the stock delivered a truly impressive head fake.

GD broke below its 20-day price channel on Thursday, negating 6.7% one-day gain following an earnings announcement a week earlier, on Jan. 23. The decline through the channel's lower boundary, $67.20, pierced a higher low set on Jan. 2 as GD's price stairstepped to a swing high of $72.01 on  Jan. 7.

Adding to the confusion is that the earnings missed the analysts forecasts by 35%, speaking volumes about the value of earnings forecasts and the rationality of markets.

The less nimble traders who played the jump after earnings no doubt saw the relatively slight decline the next day as a correction of market exuuberance, confirmed the day after by a rise, although with a lower high, and then with an increasing feeling of dread as the stock dropped day after day at an accelerating rate.

If there were a National Head-Fake Museum, this one would deserve a prominent display.

The next downside resistance on the chart is at $61.70, a lower low established on Nov. 16.

GD since January 2009 has been profitable in seven out of 10 breakouts to the downside. The average profit on successful trades, however, has been only 5.1%.

This bumps against a standard that I've been applying to my trading, because adjusting the average profit by the 66.7% success rates gives a score of 3.4%. My practice has been to reject trades that score below 5%.

Note, however, that I called it a practice, not a rule. A difference is that I don't break rules (hardly ever), but I'm willing to adjust practices to the circumstances.

My circumstance now is that we're in earnings season, and it's hard to find trades because of my rule against trading within 30 days before an earnings announcement. So my choice, some days, is to not trade or adjust a practice. That's what GD would require.

(See my essay "On the virtue of being slacker" for a discussion of how earnings seasons impacts my trading rules.)

This is GD's 16th breakout to the downside since 2009, when my database begins.

A deeper analysis shows that GD's success rate has been increasing.

I divided the 15 prior breakouts into quintiles of three apiece, with the most recent quintile being the 1st and the earliest being the 5th.

The odds of success were only 1:3 in the earliest quintile in 2009. It was 3:3 in the most recent quintile, in 2012.

The average profit for winning trades peaked at 10.1% in the 4th quintile, in 2010, and is only 4.3% in the most recent quintile.

Another approach is to calculate the average return of all breakouts in a quintile, whether they made money or not. The profits from successful trades in the first three quintiles were wiped out by large losses from failed trades, so each showed a negative yield.

That picture has changed in the two most recent quintiles, each of which showed an average profit from all breakouts.

Given that trend, I'm willing to bend my practice in favor of a trade on GD -- if I like the rest of the analysis.

General Dynamics, headquartered in the Washington, D.C. suburbs, is a major player in the U.S. defense industry, and in fact is the fourth-largest defense contractor in the world. Anyone into fighting systems will find it pleasant to browse through the company's website, which is an education into what is state-of-the-art in the world of war.

Brokerage analysts, collectively, show a 36% enthusiasm rate for GD. It's important to remember that these folks, actually, are a trailing leading indicator. What their published forecasts are now is what they were saying before the most recent earnings announcement, and so they doesn't reflect that negative surprise.

Far more to the point is the company's 18% return on equity with debt that's not too awful, at 34% of equity.

Looking at the last 12 quarters, the company has never failed to show a profit. The last two quarters have shown declines from both the prior quarter and the year before.

Nine of the last 12 quarters has shown an upside earnings surprise, and three have surprised to the downside. The three downside surprises came in the last four quarters.

So General Dynamics' earnings have been stumbling a bit, which is certainly enough to make any longer-term trader a bit nervous.

Institutions own 74% of shares, and the price is low. It takes just 74 cents in shares to control a dollar in sales. Sometimes prices are low for a reason, and in this case the low stock price in terms of sales is a serious divergence from the analysts' happy talk.

GD on average trades 3.9 million shares a today and supports a fair selection of options stike prices with open interest running to three figures around the money. The bid/ask spread on front-month, at-the-money puts is 8%, a bit out of the narrow range.

It's not a very volatile stock.

Implied volatility, based on options trading, is running at 20%, slightly below the middle of the six-month range. It had been rising since late January into Thursday, but it declined today.

Options are pricing in confidence that 68.2% of trades will fall between $62.34 and $70.04 over the next month, for a potential gain or loss of 5.8%, and between $64.34 and $68.04 over the next week.

Nearer term, there are signs of speculative fever in GD, on both sides of the equation.

Options are trading at more than double their five-day average volume, 226% for calls and 278% for puts.

Today's trading buttresses the bearish case.

The fair-trade zone on today's 30-minute chart runs from $66.20 to $66.68, encompassing 68.2% of trades surrounding the most-traded price, $66.32. With a bit more three hours left in the trading day, GD is trading below the lower bound of the zone.

General Dynamics next publishes earnings on April 24. The stock goes ex-dividend in March for a quarterly payout yielding 3.08% annualized at today's prices.

Decision for my account: These points argue in favor of a GD trade: The increasing success rate of downside breakouts, the truly tricky head fake to the downside and the fact that GD is trading below the fair price zone. The low price of the stock, suggesting a lack of confidence in the future, also helps make the bear case. The bullish financials argue against a trade, although they mainly are of interest to longer term traders.

I opened a bearish position today on GD, structuring the initial position as a bear call spread expiring in march, short the $67.50 call and short $70 call. This gives a potential maximum yield of 41%. The spread is profitable down to $68.23, providing a 3% cushion in the event the stock rises.

If the price continues to fall, I'll add to my position by buying long puts expring in May.


My trading rules can be read here.  A discussion of recent modifications to my trading methods, which haven't yet been incorporated in the original write-up, can be found here.

And the classic Turtle Trading rules on which my rules are based can be read here.

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 decision decisions for his or her own account, and take responsibility for the consequences.

No comments:

Post a Comment