Friday, December 27, 2013

NOC: Bullish on military defense

Update 4/8/2014: NOC had a substantial rise since I wrote the analysis in late December, but I never made the trade due to a trading error. I.e., I overlooked the signal. The stock closed below its 20-day price channel on April 7 and again today, so I've removed it from my Watchlist.

Northrop Grumman Corp. (NOC) is in the final leg of a rise from $91.97 on Aug. 30. Its bull signal on Thursday marked the resumption of its rise after a 13-day correction from $114.48 down to $107.21 on Dec. 12.

By the Elliott wave count, the present uptrend is enclosed within a rise of larger degree, from $27.498 on March 6, 2009, and indeed within an uptrend that began from $10.92 on May 13, 1994.

At degrees above the fifth wave that began last Aug. 30 stand three degrees of third waves. That's a Elliott way of saying that although NOC is nearing the end of its near-term rise, it still, in the longer term, has potential to the upside.

Click on chart to enlarge.
NOC 5 years 3-day bars (left), 90 days 1-hour bars
Note that the orthodox trend channel, connecting the start of waves 1 {-1} and 3 {-1} for the lower line, and setting the top line at the end of wave 1 {-1}, goes shooting off beyond the path prices actually took.

An alternate line, in red, from the start of waves 3 {-1} and 5 {-1} contains most of the price move, and even comes close to containing the end of wave 1 {-1}.

A count that set the end of wave 4 where I have wave 2 {-1} would make the red channel orthodox, but at the cost of making wave 4 malformed, with its B wave exceeding the start of its A wave, which is forbidden under the Elliott wave rules.

I'll trust my preferred count for this analysis, ignoring the black trend channel as one of the sweet mysteries charts sometimes produce. If the red channel count is indeed correct, then the {-1} degree is in its third wave rather than its fifth, and has much more upside potential than under the preferred count.

In any case, under Elliott, there is no way of determining where the present uptrending wave might end. Even the traditional support and resistance analysis is of no help, since NOC is in blue-sky territory, well above all resistance except today's high (so far) of $116.19.

This is NOC's third bull signal since the present uptrend began on Aug. 30. The two completed signals split, with the winner yielding 6.7% over 38 days and the loser having a 0.5% negative yield over 12 days. The resulting win/lose yield spread, 6.2%, is at a level I find acceptable in a trade.

Northrop Grumman, headquartered in Falls Church, Virginia, is the world's fourth-largest defense contractor, with products ranging from drones to cyber-security. It and a handful of other defense companies have developed the technologies that define 21st century warfare and the character of the modern battlefield.

Analysts are less than optimistic about Northrop Grumman's prospects, collectively coming down with a negative 85% enthusiasm rating.

The company's financials are far from negative. It reports a 20% return on equity with debt amounting to 63% of equity.

Earnings the past two years have tended to peak in the 4th quarter. That quarter in 2012 came in a couple of cents below its year-ago counterpart. The most recent quarter reported, the 3rd of 2013, came in significantly ahead of its year-ago counterpart.

The company's earnings have surprised to the upside in every quarter for at least the past three years.

The earnings yield is 7.3%, higher than 80% of aerospace and defense companies. The stock is priced at 14 times earnings, on the low side for the company's sector. It takes $1.02 in shares to control a dollar in sales. Northrop Grumman retains 71% of earnings after paying dividends.

NOC on average trades 1.5 million shares a day, sufficient to support a wide selection of option strike prices spaced $5 apart near the money. The front-month at-the-money bid/ask spread on calls is moderately high, at 8.7%.

Implied volatility stands at 20%, which is the 56th percentile of the annual range. It has been meandering sideways since mid-October. An appropriate bull play when volatility is neither high or low is to buy shares.

Options are pricing in confidence that 68.2% of trades will fall between $107.84 and $121 over the next month, for a potential gain or loss of 5.8%, and  between $111.26 and $117.58 over the next week.

Contracts are trading slowly today, with calls running at 63% of their five-day average volume and puts at 37% of average volume.

Northrop Grumman next publishes earnings on Jan. 30. The stock goes ex-dividend in February for a quarterly payout yielding 2.1%.

Decision for my account: I intend to open a bull position in NOC, structuring it as shares. 

I'll open the position if NOC maintains upward momentum in the last half hour of trading. At this point, with three hours before the closing bell, that seems unlikely. NOC fell from the opening be3ll and has continued falling throughout most of the day.

I'll add NOC to my Watchlist if the decline continues and I'm unable to trade.


My shorter-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 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.

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.

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