Tim Bovee, Private Trader: SLXP: What's a trend worth?

Salix Pharmaceuticals Ltd. (SLXP) has had quite run. The chart remains bullish, but the stock is quite expensive, with an earnings yield below 1%.

Trading coaches love to say, "The trend is your friend." Salix raises the question, "Is friendship worth price?" As a practical trader, how much am I willing to pay for a trend that may be nearing its expiration date?

The Chart

SLXP is nearing completion of the middle leg of an uptrend that began Sept. 22, 2011 from $25.64. The momentum has so far carried SLXP to $125.82, multiplying the price nearly five times.

It has been a wonderful run for bulls, but in the markets, the past need not be prologue. The question this chart must answer is how much more upside remains.

My Elliott wave analysis labels the uptrend from 2011 as wave 3 {+3} within 5 {+4}. That 3rd wave alone has accounted for nearly 90% of the rise.

Click on chart to enlarge.

SLXP 3 years daily bars (left), 60 days hourly bars (right)

Wave 3 {+3} in turn is in the final leg of its lifespan, wave 5 {+2}. Drilling deeper, I count SLXP as being in wave 3 of 3 {+1} of 5 {+2}. In other words, it is in the middle wave at two lesser degrees within a final wave of higher degree.

Waves 3 and 3 {+1} began in the spring, the lower degree wave 3 on June 5 and the greater degree wave 3 {+1} on May 9. At the {+1} degree we're looking at waves that last months, and at the base degree (wave 3), that endure for weeks.

This tells me that there is some upside remaining. Wave 3 is extending through waves of lesser degree that have about the same magnitude as their parent. The Elliott rules require this when a 3rd wave comes in shorter than both the 1st and the 5th.

An extension can last quite sometime. Under the rules, it is certainly possible for wave 3 to come to an end today, but it might also continue to rise. There is no way under Elliott to tell.

Wave 3 {+1} began from $100.52, which creates the potential for quite a significant correction after that it reaches its terminus. The correction will be followed by a further uptrend that will exceed the peak of wave 3 {+1} and then move into another correction of much higher magnitude.

Bigger picture, SLXP has been in an uptrend at the {+5} degree since 2002.

Options are pricing in confidence that 68.2% of trades will fall between $105.17 and $144.13 over the next month, for a potential gain or loss of 15.6%, and between $115.29 and $134.01 over the next week. I've marked the monthly range on the left-hand chart in blue.

Odds and Yields

SLXP has completed six bull signals since wave 3 {+3} began in November 2012. Four were successful, on average yielding 19.5% over 63 days. The two unsuccessful trades lost 4.7% over 14 days on average.

The 14.8% win/lose yield spread is quite high.

There has been only one bull signal completed since wave 5 {+2} began in April. It was a failure, losing 3.7% over nine days.

The Company

Salix, headquartered in Rahleigh, North Carolina, specializes in developing drugs to prevent and treat gastrointestinal disorders, ranging from travelers' diarrhea to colon-cancer screening.

Analysts collectively are positive about Salix' prospects, giving it a 38% enthusiasm rating.

Certainly the financials provide qualified support the optimism. Salix reports return on equity of 33%, but with a high level of debt of four times equity.

There is no trend to earnings. The last two quarters came in high tht any quarter since the 4th of 2011. Salix has surprised to the downside twice in the past three years: The first two quarters of 2013. The remainder have surprised to the upside.

The earnings yield is 0.89%, an extremely low level compared with the relatively safe instrument, 10-year Treasury notes, which have a market yield today of 2.6%. Salix pays no dividend.

Growth estimates imply a "fair" price of $74.70, meaning that shares are overpriced by 68%. I've marked that level on the left-hand chart in purple.

The stock selling for 112 times earnings and also at a steep premium to sales. It takes $7.05 in shares to control a dollar in sales.

The company next publishes earnings on Aug. 4.

Liquidity and Volatility

SLXP on average trades 1.2 million shares a day and supports a wide selection of options strike prices spaced $5 apart, with open interest running to three and four figures.

The front-month at-the-money bid/ask spread on calls is quite wide at 25%, compared to 0.5% for the most-traded symbol on the U.S. markets, the exchange-traded fund SPY.

Implied volatility stands at 54% and has been on the rise from 37% on May 9. Volatility on the S&P 500 index, by contrast, stands at 11%.

SLXP's volatility stands at the 89th percentile of the one-year range, implying that trades structured as short options spreads sold for a credit will have the best chance of success.

However, the bid/ask spread on SLXP options is too wide for my taste, so any position I entered would be structured as long shares.

Contracts today are heavily skewed toward the put side, which are running at nearly four times their five-day average volume. Calls are running at nearly double average volume.

Decision for My Account

My main problem with SLXP is the low earnings yield. This is an expensive stock. I normally pay little attention to earnings yield on my shorter-term trades but this case is extreme.

Also, the chart shows SLXP as being in a 5th and final wave from April 15. That is late in the game for opening a new position. I think SLXP will make a better play after the looming wave 4 {+3} correction has run its course.

And finally, because of the wide options spread, there is no opportunity for leverage and hedging, which makes the symbol less attractive for my purposes.

I don't intend to open a bull position in SLXP.

-- Tim Bovee, Portland, Oregon, June 23, 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.