Tim Bovee, Private Trader: AEO: A decent bear play, but not yet

Update 8/7/2014: AEO closed above its 10-day price channel on Aug. 5 and provided confirmation by trading beyond the signal level the next day. I've removed AEO from the Watchlist as a potential bull play.

American Eagle Outfitters (AEO) is potentially at the end of a long-running chart pattern that sets it up for continued decline. Or maybe not. The price needs to break below the previous major support before its future becomes clear.

That level is less than a dollar below the present price, so the chart is worth keeping an eye on, but not an immediate trade.

The Chart

The Elliott wave zoo is divided into two sections, impulse and correction, reflecting the two stages of the progress of a stock's price.

Impulse movements, in the direction of the main trend, are wonders of careful design and construction, much like the replica in miniature of Versailles, installed a few years back at great cost by your rich neighbor across town, the hedge fund manager. Look around and you'll see several carefully selected varieties of songbird, with the occasional butterfly and dragon fly adding a touch of wildness to the scene.

Impulse movements are always five waves, three in the direction of the trend and two in the contrary direction, with the middle wave never being the shortest of the three trending waves. Invariably, that's what an impulse movement is.

Correction movements, contrary to the trend, are more like the house down the block that your neighbors, the young couple forced to abandon the place after both were laid off in the Recession. The house, its roof beginning to sag, has been taken over by squatters, and the yard is overgrown with weeds and unkempt brush. Look around, however, and you'll see that the yard is filled with an incredible variety of beasts, creeping and flying, a picture of biodiversity run wild.

Correction movements come in a large number of variations with few rules to govern their construction. Analyzig them is like cutting a trail through the rain forest with a machete. For large scale movements, it can take years to understand which pattern is showing on the chart.

That's the case with AEO since the end of its pre-recession rise to $34.80, a peak attained in January 2007.

The price has traced a clear A-B-C pattern, called a zig-zag in Elliott nomenclature. The question that remains unclear on the chart is whether the pattern is indeed a zig-zag, or is it instead the beginning of an extended flat, a sideways pattern.

Click on chart to enlarge.

AEO 10 years weekly bars

If a zig-zag, then AEO has begun the 3rd wave of an impulse movement to the downside. If a flat, then AEO is near a reversal to the upside as the 2nd wave continues.

I'm working with a 10-year chart because the ambiguity is at that large scale, but the impact is in the very near future. The B-wave low in September 2011 was $10.01. The low of the present decline, which I've labeled as a 3rd wave, is $10.12, set on May 22, 2014.

A substantial decline below $10.01 would buttress the case for the 2nd wave being over and the 3rd wave underway. A substantial reversal to the upside would mean that a sideways correction was continuing.

That's a lot of ambiguity and for me, argues for a wait-and-see approach.

Odds and Yields

Bear signals on AEO since the present decline began in September 2012 have even odds of producing a profit.

Out of 10 completed signals, five were successful with an average yield of 6.5% over 29 days. The five unsuccessful signals produced on average at 5.9% loss over 14 days.

The yield spread is positive, but barely so, at 0.6%.

The Company

American Eagle Outfitters, headquartered in Pittsburgh, Pennsylvania, operates 1,090 retail clothing stores in the United States and Canada, squarely aimed at the 15-to-25 demographic.

Brick-and-mortar sales account for most of its market cap, but it also has a significant online and catalog presence, with those orders contributing nearly a quarter to its market cap.

Analysts in the aggregate are extremely pessimistic about American Eagle Outfitters' prospects, coming down with a negative 58% enthusiasm rating.

The company is profitable. It reports return on equity of 10% with no long-term debt.

Like all American clothiers, American Eagle Outfitters' earnings peak in the 4th quarter each year, reflecting results of the Christmas shopping season.

The 4th quarter 2013 earnings were the lowest of the past four, an especially disappointing result in comparison with its year-ago counterpart, which was the highest of the period. Earnings have surprised to the downside four times in the past four years, most recently in the 2nd quarter of 2013.

American Eagle Outfitters has an earnings yield of 2.81%, compared to a 2.54% yield on the 10-year U.S. Treasury note.

The quarterly dividend yields 4.66% annualized at today's prices. The dividend:earnings ratio is 165:100, meaning that the company is paying an outsized portion of its earnings directly to shareholders as a dividend.

The "fair" price of shares, when the earnings yield and dividend are taken into account, is $5.30, suggesting that market is pricing the shares at about double what they're worth by this measure.

The stock is selling for 36 times earnings but at a steep discount to sales. It takes only 64 cents in shares to control a dollar in sales.

Institutions own 81% of shares.

American Eagle Outfitters next publishes earnings on Aug. 18. The stock goes ex-dividend in September for a quarterly payout of 12.5 cents per share.

Liquidity and Volatility

AEO on average trades 3.3 million shares a day and supports a wide range of option strike prices with open interest in the four and five figures.

The front-month at-the-money bid/ask spread on puts is 8.3%, compared to 0.4% for the most-traded symbol on the U.S. markets, the exchange-traded fund SPY.

Implied volatility stands at 39% and has been rising since May 21. Volatility stands at the 34th percentile of the one-year range, suggesting that long options spreads, bought with credit, would be the most successful strategy.

Options are pricing in confidence that 68.2% of trades will fall between $9.50 and $11.92 over the next month, for a potential gain or loss of 11.3%, and between $10.13 and $11.29 over the next week. I've marked the implied monthly range in blue on the chart.

Contracts are skewed toward puts, which are running 13% above their five-day average volume, compared to calls, which are at about one third of average volume.

Decision for My Account

The chart's ambiguity is significant. Otherwise, AEO is a perfectly good bear play -- highly liquid, overpriced and a bad rep among analysts. Going short on a high-dividend play like AEO always seems wasteful to me, but capital gains in a decline would certainly make up for it.

But, the ambiguity can't be wished away.

I find AEO to be a decent bear play, but not yet. I'll like it much better once it has fallen below $10.01, the level that marked the end of the B wave in the present correction.

That level is within the trading range over the next month implied by options pricing, so it is not at all out of reach.

I won't trade AEO today. I shall add it to my Watchlist for consideration below $10.01.

-- Tim Bovee, Portland, Oregon, July 14, 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 from time to time 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.