Friday's Prospects: Round 2

Only one of the seven symbols that survived my first round was analysis was a potential bull play: CQH. It is in only its sixth month of trading, and my rules require at least a year of market history before I'll consider opening a position.

Of the bear signals, one, DK, failed confirmation.

Three have insufficient open interest on their options for me to use them in building a bear position: SIR, STAR and DSCI.

One symbol, BID, has a bullish evaluation from Zacks; I prefer that my trades align with the Zacks rating.

That leaves AXLL, which meets the requirements but with one immediately apparent blemish: A front-month at-the-money bid/ask spread that spans a double-digit percentage.

I could, just barely, construct a bear position from those options, but frankly, that wide spread is a broader chasm than I care to overleap.

(See "Friday's Prospects" for a description of the first round of analysis.)

I next turned to the supplemental table of large-cap bear signals that failed the odds analysis but have options that are sufficiently liquid for trading.

MET's chart is still, marginally, uptrending, which would be counter to the bear signal. YUM has a bullish rating from Zacks that is contrary to the bear signal.

My preference is to avoid countertrend trades and also to avoid trades that run contrary to the analytical consensus.

That left AMTD and IBM, both of which meet my basic criteria. Digging a bit deeper, however, I found indication that when dividends are considered, both stocks are priced at levels that are in line with earnings growth.

The basic calculation, called the price/earnings/growth ratio, or PEG, is to divide earnings per share by earnings growth. I use the figures that Zacks makes available even to non-subscribers (although I do subscribe to this excellent service).

IBM has a peg of 1.28, which means that it is overpriced by 28%. However, it pays a 2.36% dividend, and when that is accounted for, the dividend-adjusted PEG (let's call it the PEGY, for "Yield") is 0.99, meaning it is underpriced by 1%.

AMTD has a PEG of 1.01 and so is overpriced by 1%, but its 1.62% dividend gives it a PEGY of 0.94, meaning it is underpriced by 6%.

Some analysts who use the PEG say that a ratio of one means that the stock is fairly priced. I think the concept of a fair price is nonsensical in the markets, where prices are all a balance of hope and fear.

My interpretation is that a one means that hope and fear have all been reflected in the price, and a score below one means that fear -- the bear side -- is more than fully represented. My theory is that a bear play needs some hope in the price so that disillusioned traders can exit, triggering a price decline.

Normally, for short-term trades, I pay more attention to the chart and very little to the fundamental valuations.

But for these large-cap potential bear plays, I've already ignored a major technical component: The odds of a successful trade. Since June 23, 2013 IBM has been profitable in only a third of its bear signals, and AMTD has no successful bear plays in that period.

Numbers like that make the valuation more important. PEG and PEGD don't have immediate impact, but I'm far more comfortable going short an overpriced stock than an underpriced one.

Add to that the reality that Thursday was a heavily bearish day across the markets, and that gives me reason to be doubly cautious.

I'm adding IBM and AMTD to my Watchlist, with the intent of delaying confirmation by a day. I'll check them on Monday and if they continue to trade beyond their breakout levels, then I'll consider a trade in one or both. However, I don't intend to trade either today.

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.

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.