Tim Bovee, Private Trader: GD: Bullish on weapons of war

Update 7/30/2014: GD's "tumbled a bit" deserved to be taken more seriously. At first glance, wave 5 appears to have completed its work on July 25, and wave 4 {+1}, correcting the rise from April 2013, has begun.

I've exited my bull position after the price closed below the stop/loss level on July 29 and confirmed the exit signal the next day. The price remains within the 10-day price channel and so GD will go on the Roll Shelf.

My practice is to defer calculating profit and loss until a roll series is complete.

Click on chart to enlarge.

GD 10 days 5-minute bars

Update 7/24/2014: GD has tumbled a bit in the last 90 minutes of trading, but it remains above its opening price and as I write, half an hour before the closing bell, it is above the reset-day level.

That's sufficient momentum for my taste. I've opened a bull position, structured as a bull call options spread, long the $125 call and short the $130 put, bought with a debit and expiring Nov. 21.

The leverage is 13:1.

General Dynamics Corp. (GD) has been around for more than a century. My charts only span 20 years maximum, but that's a sufficient time to see that GD has been on a bullish roll for a very long time.

Unlike many of large caps, which have recently faltered into ambiguity, GD decisively shouts out that there is still room to rise. Although, here, too, there is some ambiguity to be seen.

The Chart

The long count in Elliott wave analysis shows that GD is in the final leg of a rise from March 2000 that has multiplied the price more than seven-fold.

The end, however, is anything but nigh. GD is in the 3rd -- middle - portion of that rise from March 2000, a movement that began in September 2011 from $53.95. When it is complete, GD will do a downside correction that will remain above, perhaps well above, $53.95 before pushing up again to new highs.

Click on chart to enlarge.

GD 20 years monthly bars (left), 4 years daily bars (right)

The wave up from April 2013, which I've labeled as 3 {+1}, is poorly differentiated in its internals and appears to me to be an extended 3rd wave within an extended 3rd.

I've made an attempt to count the waves at the base degree, but with little confidence in the result.

If my count is correct, then wave 3 {+1} that began April 18, 2013 from $65.37 is in its final wave to the upside, so a correction of the rise from that level may well be near.

It is impossible to say with certainty how deep the correction might be, but several major Fibonacci retracement levels are common:

$100.32	38.2%
$93.65	50.0%
$86.97	61.8%

The time required by a correction at this degree would typically be measured in months, not years.

The ambiguity on the GD chart comes with the month-long decline to July 10 that preceded the rise to today's high. What if the June 9 high is indeed the wave 5 peak, and the subsequent decline and rise are the first steps in the correction? Even with today's higher high, that interpretation is still allowed under the Elliott rules of framing.

I rejected that interpretation based on the magnitude of the decline, a mere 13.6% of the rise from April 2013 to the June high. That seems to shallow for a correction of the {+1} degree on this chart, but it is not entirely unthinkable.

Odds and Yields

GD has completed five bull signals since wave 3 {+1} began in April 2013. Four were successful, on average each yielding 8.1% over 50 days. The one unsuccessful trade lost 0.9% over 17 days.

The win/lose yield spread is quite good, at 7.2%, as is the success rate, 80%.

The Company

General Dynamics, headquartered in Falls Church, Virginia, is a major U.S. defense company, designing and building combat systems for the U.S. military and allied forces, as well as aircraft, information systems and marine craft for military and civilian use.

In 2012 it ranked as the world's fifth-largest defense contractor by revenues.

Gulfstream jets, a mainstay of globe-trotting CEOs, is a General Dynamics product, as is the F-16 jet fighter, the Abrams battle tank, the C4 secure communications and information system and a number of ocean-going vessels for the U.S. Navy.

Perhaps most exciting in a market where change is driven by the glacial base of federal contracting regulations, General Dynamics is a player in military robotics, including aerial drones.

Analysts, certainly, are optimistic about General Dynamics' prospects, collectively coming down with a 33% enthusiasm rating.

The company reports return on equity of 19% with debt running at 25% of equity.

Earnings have tended to fluctuate within a profitable range over the past three years. Three quarterly reports, both in 2012, have surprised to the downside. The rest have all been upside surprises.

The earnings yield is 5.86%, compared to 2.51% for 10-year U.S. Treasury notes. The dividend yield is 2.04% and amounts to 0.35% of earnings.

Growth estimates combined with the dividend imply a "fair" price of $67.88. By that reasoning, GD is overpriced by 130.29%. I've marked the "fair" price level on the right-hand chart in purple.

GD stock is selling at 17 times earnings, and also at a premium to sales. It takes $1.33 in shares to control a dollar in sales.

Institutions own 87% of shares.

General Dynamics next publishes earnings on Oct. 21. The stock goes ex-dividend in October for a quarterly payout of 62 cents per share.

Liquidity and Volatility

GD on average trades 1.4 million shares per day and supports a wide selection of option strike prices spaced $5 apart, with open interest running mainly to three and four figures. The front-month at-the-money bid/ask spread on calls is 5.7%, compared to 0.5% on the most-traded symbol on the U.S. markets, the exchange-traded fund SPY.

Implied volatility stands at 17%, compared to 12% for the S&P 500 index, and has been falling from 22% beginning July 17. GD's volatility stands at the 18th percentile of its one-year range, suggesting that options spreads bought with a debit have the best chance of success.

Options are pricing in confidence that 68.2% of trades will fall between $115.75 and $127.71 over the next month, for a potential gain or loss of 4.9%, and between $118.86 and $124.60 over the next week. I've marked the one-month range on the right-hand chart in blue.

Contracts are trading slowly today, with puts running at 90% of their five-day average volume and calls at 52% of average.

Decision for My Account

I consider this to be a reasonable bull play under my shorter-term rules. If a new high had not been set today, then I would be reluctant. However, the new high tells me that wave 3 {+1} is still under way, giving me more upside to work with.

I intend to open a bull position today if upward momentum continues in the half hour before the closing bell. If momentum falters, then I'll put GD on the Watchlist for later consideration.

-- Tim Bovee, Portland, Oregon, July 24, 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.

From time to time 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.