Tim Bovee, Private Trader: NSR: A trend running on fumes

NeuStar Inc. (NSR) has been on the decline for nearly a year, and a break below the 20-day price channel on Monday signaled more bearish prospects ahead.

The chart, however, suggests that the downtrend is mature and that an upward correction is approaching. And there is a news component to NSR's recent price movements, adding a huge element of uncertainty to any potential trade.

The Chart

An Elliott wave interpretation of the NSR chart hinges entirely on the question of what degree to assign to the decline that began July 31, 2013 from $57.29. the movement has more than halved the price.

The 10-year chart on the left shows the major turning points at the {+3} degree to be half a year up to more than a year more apart. The major turning points are running from one month to three months apart on the one-year chart to the right.

Click on chart to enlarge.

NSR 10 years weekly bars (left), 1 year daily bars (right)

Given that time difference, it seemed reasonable to push the right-hand chart labels down a degree or two. I've chosen to place them at the {+1} degree, but they might well be {+2} or even {+3}. There's no way to tell at this point.

In fact, it's possible to make a strong argument that the proper degree is {+3}, based on how much of the rise from 2009 has been covered. The downward move that began last July is moving toward the 78.6% Fibonaccci retracement level of $22.30, an extremely deep retracement level.

A lower degree movement would be unlikely to fall so far

It matters because the degree counted in the right-hand chart is in its 5th wave down, the final wave before a correction both 1st waves and A waves. The degree determines the significance of the upside correction that lies ahead.

It is clear that at the higher level, the downward movement is wave A {+3} of 4 {+4}. An A wave is five waves down, followed by a B wave that can have a three-wave pattern or something more complex, followed in turn by a C wave that again has five waves down.

NSR's chart is clearly bearish, but it is an extremely mature trend. A chart like this suggests that there is very little fuel remaining to carry the price down much further. The trend is running on fumes.

Options are pricing in confidence that 68.2% of trades will fall between $20.13 and $29.09 over the next month, for a potential gain or loss of 18.2%, and between $22.46 and $26.76 over the next week. I've marked the monthly range on the left-hand chart to blue.

Odds and Yields

NSR has completed four bear signals since the downtrend began last July. Three were successful, on average yielding 13.9% over 29 days. The one unsuccessful signal lost 5.2% over eight days.

The 75% success rate lends authority to the present bear signal; NSR hasn't been prone to whipsaws. The 8.7% win/lose yield spread means that the profits from successful signals far outweight the losses from false positives.

The Company

NeuStar provides the information infrastructure needed for the U.S. and Canadian telecommunications networks to function. It manages area codes and phone numbers that enables call routing, provides services that enable internet service providers, mobile networks and cable TV systems to function, provides domain name and digital rights services and operates the authoritative directory for short codes used in some SMS operations (also known as texting).

It's not glamorous work, something along the lines of managing a traffic light system, but it keeps the traffic moving.

An important portion of NeuStar's business depends upon a contract with federal regulators. Since renewal depends upon bureaucratic decision-making, it is a large element of uncertainty. The latest on contract, reported by Todd Shields of Bloomberg News, can be read here.

Analysts skew toward pessimism in their assessment of NeuStar's prospects, collectively coming down at a negative 71% enthusiasm rating.

The company has a stunningly high return on equity, at 32%, with debt also a bit on the high side at about the same amount as equity.

The earnings yield is 10.08%, compared to 2.63% for 10-year U.S. Treasury note. The stock pays no dividend.

The stock is selling for nearly 10 times earnings and at a premium to sales, as well. It takes $1.61 in shares to control a dollar in sales.

Earnings have been rising quarter after quarter from the start of 2013 onward and current vs. year-ago quarter since the 2nd quarter of 2012. Earnings have surprised to the downside three times in the past three years, most recently in the 1st quarter of 2014.

Growth estimates imply a price of $31.47 for NRS, meaning that the market anticipates an additional 22.1% in downside potential. I've marked the implied price on the right-hand chart in purple.

Institutions own nearly all of the shares.

NeuStar next publishes earnings on July 28.

Liquidity and Volatility

NSR on average trades 1.6 million shares a day and maintains a wide range of option strike prices spaced a dollar apart, with open interest ranging from four figures downward.

The front-month at-the-money bid/ask spread on puts is 18%, far wider than I'm generally willing to trade. The spread on out-month puts, which I would use for some strategies, is wider, at 25%.

By contrast, the front-month spread on puts is only 1.9% for the most-traded symbol on the U.S. markets, the exchange-traded fund SPY.

I can't construct a bear position without options, and so that spread appears to be a deal killer.

Implied volatility stands at 63%, compared to 11% for the S&P 500 index, and has been falling from its annual peak of 125% since May 5. NSR's volatility is at the 41st percentile of its one-year range, suggesting that short shares or an options spread with similar characters, such as a synthetic short futures spread, would have the best chance of success.

Contracts today are heavily skewed toward puts, running at 2.5 times the five-day average volume. Calls are running at 73% of average volume.

Decision for My Account

The options price spread is too wide for me to trade, and I won't be opening a bear position in NSR.

It's not a bad bear play, although the financials tell at odds with the financials. NSR pairs bullish earnings and great return on equity but bearish pricing in the marketplace.

The fact that regulators are right now in the midst of questioning whether the contract will again go to NeuStar argues against taking the bear play. If they get the contract, then the price will rising, causing the position to lose. If they don't get the contract, then arguably most of the damage to the strike price has already been done in anticipation of the decision, and there will be little downside benefit.

-- Tim Bovee, Portland, Oregon, June 10, 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.