Tim Bovee, Private Trader: RL: Not quite haute couture

Update 9/17/2014: RL rose above the beginning of wave 5 to the downside without making a lower low at the terminus, negating my count. It appears that rather than wave 5 beginning on Sept. 11, wave 4 is continuing into a more complex sideways pattern.

The rise put RL above its 10-day moving average, and so no roll will be possible under my rules.
The share prices rose by $5.8% over 52 days. The bearish options position produced a 129.5% loss.

Update 9/26/2014: I've opened a bear position in RL, structuring it as a bear put spread, long the $170 puts and short the $165 puts, bought with a credit and expiring Jan. 15. The position provides 2:1 leverage.

Ralph Lauren Corp. (RL) last year ended its uptrend of more than a decade and has since been skidding down the walkway in a decline that, for bullish investors, resembles a bear-skin robe more than haute couture.

The Chart

RL, at its post-recession peak, had nearly doubled its pre-recession high, making it an outlier among the stocks I've analyzed.

The Elliott wave frame declares May 2013 peak to have been the 5th wave of a very high degree, putting RL in a correction of such magnitude that it will look like a downtrend for a very long time to come.

Click on chart to enlarge.

RL 20 years monthly bars (left), 19 months daily bars (right)

The five waves up that culminated last year took more than a decade to complete their work, and I would expect the correction to be of a similar magnitude. While looking at this chart, we can profitably contemplate fashion in the mid-2020s.

Our immediate task, however, is far less grandiose: To identify where RL stands as it begins its journey down wave A {+4}.

A waves are composed of five-wave patterns, much like uptrending waves turned on their heads. These are called "impulse waves" in Elliott. The largest degree of wave in my count, A {+4}, is a corrective pattern. Corrections tend to be based on three-wave movements, although some of these have impulse waves internally.

In the right-hand chart, I've counted the major movements as the base degree. This is clearly a mere guess. There's no way to say at this point how the magnitude of the price movements this year and last relate to the magnificent swings of the {+4} degree.

By my count, the 1st wave down, which I've called wave 1 {+1}, is in its 5th and final internal wave. Under the Elliott wave rules, it can be expected to carry below the end of wave 3, perhaps far below.

From today's opening price, such a decline gives RL downside potential of 14% at a minimum, and potentially much more.

Odds and Yields

RL has completed six bear signals since the May 2013 peak. They split evenly between winners and losers. The three successful trades yielded 3.1% over 59 days, on average. The unsuccessful trades lost 3.6% over 16 days.

These are not particularly impressive results, especially the negative half a percent win/lose yield spread.

The Company

Ralph Lauren, headquartered on Madison Avenue in New York City, is one of the best known names in clothing design. It also markets accessories, fragrances and home furnishings under its brands. It operates more than 600 stores globally, and also distributes its products to other retailers.

Analysts are generally optimistic about the company's prospects, collectively coming down with a 14% enthusiasm rating.

Ralph Lauren reports return on equity of 19%, with debt amounting to only 8% of equity.

Earnings tend to peak in the winter holiday quarter, occasionally in the prior autumn quarter. Peak quarter earnings were down in 2012 compared to 2011, but up in 2013.

There has been only one downside earnings surprise in the past three years, in 2013. All other quarters have surprised to the upside.

The earnings yield is 5.04%, compared to 2.54% for the 10-year U.S. Treasury notes, and company pays a dividend yielding 1.1% annualized at today's prices.

Growth estimates, combined with the dividend, implying a "fair" price of $118.46, making RL overvalued by 39%. I've marked this left on the left-hand chart in purple.

The stock is selling at 20 times earnings, and at a premium to sales. It takes $1.93 in shares to control a dollar in sales.

Institutions own 94% of shares.

Ralph Lauren next publishes earnings on Nov. 4, 2014. The stock goes ex-dividend in December for a quarterly payout of 45 cents per share.

Liquidity and Volatility

RL on average trades 980,000 shares a day and supports a remarkably wide selection of option strike prices spaced $5 apart, with open interest running to three figures near the money.

The front-month at-the-money bid/ask, spread on puts is 7.1%, compared to 0.4% for the most-traded symbol on the U.S. markets, the exchange-traded fund SPY.

Implied volatility stands at 20%, compared to 15% for the S&P 500, and has been rising from a low of 16% set on Sept. 12. The decline to that level began from a peak of 31% on Aug. 5.

Volatility now stands in the 29th percentile of that range, suggesting that the most successful trades will be long option spreads bought with a credit -- positive Theta, or time decay, is the technical term.

Options are pricing in confidence that 61.8% of trades will fall between $154.48 and $173.77 over the next month, for a potential gain or loss of 5.9%, and between $159.49 and $168.76 over the next week.

Contracts today are skewed toward puts, which are running 46% above their five-day average volume. Calls are running 6% below average.

Decision for My Account

It is a bearish chart, and there is nothing else in the picture that detracts from a bear play under my shorter-term rules. I intend to open a bear position in RL if it shows downward momentum in the half hour before the closing bell. If momentum falters, then I'll place it on the Watchlist for later action.

I'll structure the trade as a bear put spread expiring in January.

-- Tim Bovee, Portland, Oregon, Sept. 26, 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.