Tim Bovee, Private Trader: DG: Dawn of the Bear

Update 7/30/2014: I've exited DG after it closed above its stop/loss level and am placing the symbol on the Roll Shelf for later entry. My practice is to not calculate profit and loss until after the entire roll series is complete.

The chart to me suggests that this is just an upward correction in a continuing downturn. However, my rules on exits don't allow me to second-guess the signal. If the primary trend is still pointing down, then I'll re-enter after the situation becomes clearer.

Click on chart to enlarge.

DG 20 days 15-minute bars

Update 7/16/2014: DG continued its downward momentum and I've opened a bear position, structuring it as a vertical spread bought with a debit, long the $57.50 puts and short the $55 puts, and expiring Nov. 21. The position is equivalent to about 34 shares, with nearly 4:1 leverage.

Dollar General Corp. (DG) peaked on June 9 and has begun a downtrend, in the process givings its first bear signal since May 23.

The historical odds against a successful bear play are daunting, 5:1 against. But if June 9 was the peak, it marks the end of a rise that began more than four years ago. And that in turn implies the end of history for DG and the first rays of a bearish dawn.

The Chart

DG peaked at $65.99 on June 9, completing the rise that began in January 2013 and culminating an uptrend that began in February 2010 from $21.30.

The price has since begun a sharp decline, although at a degree several steps below that of the main trend.

My main question of this chart, phrased in the vocabulary of Elliott wave analysis, is whether the June 9 peak is indeed the end of wave 5 {+3} to the upside. Or is wave 5 {+3} experiencing an exceptionally deep correction that will soon reverse and carry the price above the $65.99 level?

Is $65.99 truly a peak, or is it a mere way station on the path to bullish glory?

Click on chart to enlarge.

DG 2 years daily bars (left), 30 days hourly bars (right)

That question will be answered explicitly if the price drops below the beginning of wave 5 {+3}, which is the $53 level beginning May 30.

Until that day, I must look for implicit clues.

Wave 5 {+3} is shorter than the preceding impulse movements of the same degree. However, wave 3 {+3} is next longest. If wave 5 {+3} were to extend past $67.32, that would leave wave 3 {+3} the shortest of the three, in clear violation of the rules of Elliott wave analysis.

The look of the chart seems to back up my present count. The magnitudes of the impulse waves are comparable, with their lengths running from $12.99 to $15.44. In terms of time, wave 3 {+3} laswted 230 days, compared to wave 1 {+3}'s 145 days.

The length of the 1st wave is 63% of the 3rd wave, close to the 61.8% Fibonacci ratio, but not quite identical.

Wave 5 {+3} is totally disproportionate to its fellows, having lasted only 10 days.

In other words, magnitude argues for treating $65.99 as a peak, but duration argues against it. Elliott wave analysis is far more accurate in assessing magnitudes than it is durations. Actually, in my experience, timing in Elliott is never much more than a roll of the dice. So I'll put my trust in the magnitude argument and consider $65.99 to be a true peak.

The decline that has followed the peak counts as a clear five-wave impulse move, with the 5th wave still in progress. I've labelled the waves as the base degree, three degrees below the {+3} degree in my discussion of the previous uptrend. But, if fact, there is no way to tell yet what degree we're looking at in counting the decline.

So far the 3rd wave down is the longest of the three, but the 5th wave has lasted a longer period of time: 13 days, compared to 10 days for the 3rd wave and three days for the 1st wave. Generally, 3rd waves tend to be the longest lasting of the three.

The decline could be part of a new major downtrend, or it could be a correction of an uptrend that will move DG far higher. There's no way to tell this soon into the decline.

The cautious trader will wait until the price declines below $53, the starting point of wave 5 {+3} to the upside. However, my judgement of the chart concludes that a bearish bet under present circumstances is not overly risky.

Odds and Yields

DG has completed no bear signals since the June 9 peak, and none since wave 5 {+3} began on May 30.

Up one degree, the period beginning with wave 5 {+4} on Jan. 3, 2013 completed six bear signals.

Only one was successful, yielding 1.1% over 19 days. The five unsuccessful trades on average lost 5/9% over 17 days. The resulting win/lose yield spread is a horrifying negative 4.9%.

These are not the sorts of odds I want to trade. However, if the June 9 reversal from $65.99 was indeed a major peak, then I would argue that DG is facing a new day, and pre-peak statistics are irrelevant.

The situation has changed. Under that assessment, DG is still a viable prospect for trading.

The Company

Dollar General, headquartered in Goodlettsville, Tennessee, is in the business of selling brand name goods for ultra-cheap prices, with a focus on the consumables that are the stuff of daily living, from toothbrushes to toilet bowl cleaner, with a selection of goods costing only one dollar to justify the chain's name. It operates more than 11,000 small-box stores in 40 states.

Analysts are rather meh! about Dollar General's prospects, coming down with a negative 12.5% enthusiasm index.

The financials are worth a small cheer, with return on equity of 20% and debt amounting to 62% of equity. The debt is too high for DG to count as a growth stock, but it's not a dizzying height.

Like most retailers, Dollar General's earnings peak in the 4th quarter, which covers the Christmas shopping season.

Earnings in that quarter have come in consistently higher than the prior quarter over the past three years. However, the most recent 4th quarter produced a downside surprise, as did the quarter that followed. Only one other quarter has surprised to the downside, the 1st quarter of 2013.

The earnings yield is 5.8%, compared to a 2.54% yield on 10-year U.S. Treasury notes. The company pays no dividend.

Earnings growth implies a "fair" price of $50.26 per share, suggesting that DG is overpriced by about 10%. That's a good thing for a bear play because it provides a larger field for traders' fears to play out.

I've marked that price in purple on the left-hand chart.

The stock is selling for 17 times earnings but at near parity for sales. It takes 95 cents in shares to control a dollar in sales.

Institutions own 93% of shares.

Dollar General next publishes earnings on Sept. 2.

Liquidity and Volatility

DG on average trades 4.2 million shares a day and supports a wide selection of option strike prices spaced $2.50 apart near the money, with open interest running to four and five figures.

The front-month at-the-money bid/ask spread on puts is 13.7%, a bit wider than I like. That compares to 0.5% for the most-traded symbol on the U.S. markets, the exchange-traded fund SPY.

Implied volatility stands at 26%, compared to 11% for the S&P 500, and has been working its way downward from a near-term peak of 30% on June 20.

DG's volatility stands at the 21st percentile of its one-year range, suggesting that the trades most likely to succeed will be structured as long spreads bought with a debit.

Options are pricing in confidence that 68.2% of trades will fall between $51.26 and $59.54 over the next month, for a potential gain or loss of 7.5%, and between $53.41 and $57.39 over the next week. I've marked the month range on the left-hand chart in blue.

Contracts today are skewed heavily toward puts, which are running at nearly four times their five-day average volume. Calls are running at 47% above average volume.

Decision for My Account

It comes down to the chart and the odds, really. If June 9 indeed was the peak, then a new day has dawned for DG, casting long bearish shadows in the morning mist. Under that scenario, the bad odds against trading success with bear signals really aren't important.

As I read the chart, that bearish day has indeed dawned. I intend to open a bear position in DG if downward momentum continues into the half hour before the closing bell. If momentum falters, then I'll put DG on the Watchlist to trade once momentum resumes.

-- Tim Bovee, Portland, Oregon, July 16, 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.