Tim Bovee, Private Trader: NSC: Picking up steam

Update 10/10/2014: NSC closed blow its 20-day price channel and I've removed it from the Roll Shelf, ending the series.

During the 20-day lifespan of the one bull position I held in NSC, the stock declined by 2.9%, or 53% annualized. My options spread produced a 42.22% loss on debit, or 770.6% annualized.

Update 10/8/2014: I've exited my position in NSC after the price closed below its stop/loss level. The price remains above the lower boundary of the 10-day price channel and so is eligible for a roll forward into a new position. That being the case, I'll delay calculating profit or loss until a roll is no longer possible.

Update 9/18/2014: NSC closed above its 55-day price channel on Sept. 17 and confirmed the entry signal today by trading still higher. I've opened a bull position in NSC, structured as bull call option spreads, long the $110 call and short the $115 call, bought with a credit and expiring Dec. 19.

Update 9/8/2014: NSC fell sharply back into its 20-day price channel, negating the bull signal, after attaining a higher high. I'm keeping it on the Watchlist with an alert to revisit it upon a fresh break above today's high, $109.70.

Norfolk Southern Corp. (NSC) has broken out to a new high, suggesting the train is pulling out of the station and picking up steam. Time to hop aboard?

The Chart

NSC broke above its 20-day price channel on Sept. 2, confirming the bull signal the next day. However, I deferred the trade until a true breakout occurred, in the form of a close above the July 23 high of $108.84, the 55-day price channel. (See my Sept. 2 post "Friday's Outcomes: NSC and TSEM" for the reasoning behind that decision.)

That happened on Sept. 5. The stock must trade above that level on Monday, Sept. 6, in order to confirm the break above the 55-day channel. No confirmation; no trade.

Click on chart to enlarge.

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

The break was needed to clarify the nature of the low on Aug. 6. Was it the terminus of wave 4 {+1}, the end of a counter-trend correction, or was it the endpoint of wave A of the base degree, the initial leg of an ongoing correction.

The rise above the wave 3 {+1} peak, the July 23 high, shifts the preponderance of evidence toward the conclusion that wave 4 {+1} has indeed ended, and wave 5 {+1} is underway.

However, it is not entirely conclusive. The 2nd wave of a correction, a B wave, can indeed move beyond the end of the preceding trending wave. Most often, in my experience, the B wave ends prior to that level.

The counterargument is that wave 4 {+1}, if complete, is disproportionate to other waves of the same degree. The first countertrend correction, wave 2 {+1} lasted for 91 days. The trending waves were even longer: Wave 1 {+1} endured for 186 days and wave 3 {+1}, for 327 days.

By this count, wave 4 {+1} had a duration of only 14 days.

The rules of Elliott wave analysis don't require that waves within the same degree be proportional. But they often are, and a discrepancy of this magnitude gives me pause.

NSC's movements over the next week will clarify whether the primary count or the alternate count ("Alt:" on the left-hand chart) is correct. A continued rise suggests the primary count is correct; a reversal below the breakout level suggests that alternate count is correct. Meanwhile, NSC is on my Watchlist, where I can keep an eye on it.

Odds and Yields

NSC has completed six bull signals since wave 3 {+2} began on Nov. 16 2012, splitting evenly between success and failure. The three successful trades gained 13.3% over 65 days, on average. The unsuccessful trades on average lost 2.2% over 30 days.

The resulting 11.1% win/lose yield spread is quite impressive.

The current bull signal is the first of wave 5 {+1}, which began Aug. 6.

The Company

Norfolk Southern Corp., headquartered in Norfolk, Virginia, is a railroad operating more than 24,000 miles of track in the eastern United States. It is the fourth largest of the seven Class 1 railroads in North America and is best known for hauling coal.

Analysts collectively give a negative assessment of Norfolk Southern's prospects, giving it a negative 33% enthusiasm rating. It is ranked neutral by Zacks Investment Research, the service I use to short-cut my fundamental analysis.

The company reports a return on equity of 17% with a high level of debt amounting to 73% of equity.

Earnings have been without a trend but have been consistently profitable over the past three years. The company has produced an upside earnings surprise in all but one quarter; the downside surprise was in the 2nd quarter of 2013.

The earnings yield is 5.63%, compared to 2.46% on the 10-year U.S. Treasury notes. In addition, Norfolk Southern pays a dividend yielding 2.08% annualized at today's prices.

Growth estimates combined with the dividend imply a "fair" price of $93.77 per share, suggesting that the stock is overvalued by 17%. I've marked the growth-implied price on the left-hand chart in purple.

The stock selling for 18 times earnings and is priced at a steep premium to sales. It takes $2.96 in shares to control a dollar in sales.

Institutions own 60% of shares.

Norfolk Southern next publishes earnings on Oct. 22. The stock goes ex-dividend in October for a payout of 57 cents per share.

Liquidity and Volatility

NSC on average trades 1.2 million shares per day and supports a wide selection of optoin strike prices spaced $2.50 apart near the money.

The front-month at-the-money bid/ask spread on calls is 10.7%, compared to 1% on the most-traded symbol on the U.S. markets, the exchange-traded fund SPY.

I'm generally wary of spreads in the double digits, so NSC is a bit wider than I prefer.

Options are pricing in confidence that 68.2% of trades will fall between $104.53 and $114.57 over the next month, for a potential gain or loss of 4.6%, and between $107.14 and $111.96 over the next week. I've marked the one-month range on the left-hand chart in blue.

Contracts on Friday were trading near their five-day average volume, with calls 9% above average and puts 23% above average.

Decision for My Account

I'm not ready to make a decision yet. I want to see what happens with the present breakout above $108.84.

If my primary count is correct, then the chart is bullish and there is much to recommend a trade. The stock is priced quite high, but that's normal for a momentum play. My strategy is to jump on a train of ongoing enthusiasm and ride it for awhile. I'm more of a momentum-picker than a stock-picker.

So the question whether the momentum is continuing. If NSC retreats back within the 55-day price channel within the next few days, then I'll reject it. But for now, it stays on my Watchlist as a viable potential trade.

-- Tim Bovee, Portland, Oregon, Sept. 6, 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.