Tim Bovee, Private Trader: DE: Plowing the downslope

Update 10/16/2014: The price broke above its 10-day price channel on Oct. 15 and confirmed it by trading above the channel today. I've removed DE from the Watchlist and will no longer watch for an opportunity to open a bear position, at least until there is a fresh breakout below the 20-day price channel.

Update 10/8/2014: DE began a small-scale uptrend in the early afternoon that carried the price above the prior day's open. With such contrarian momentum, I've decided not to open a bear position in DE today and am instead placing it on the Watchlist for later consideration.

Deere & Co. (DE) has been on the decline since May as it traces out a largely sideways correction. Although it lacks the power to plow the downslope, I judge that it has enough horsepower for the short haul.

The Chart

Elliott wave framing shows DE to be in the 3rd wave down -- often the most dynamic of the set --within a correction off of the 2011 peak. I've labeled it as wave 3 {+1}.

Beginning from $94.89 on May 8, it has already fallen past the minimum level required by the Elliott wave rules: The terminus of the 1st wave in the series on $82.61 on June 24. It is impossible under Elliott to set a target for the wave.

Click on chart to enlarge.

DE 20 years monthly bars (left), 4 years 2-day bars (right)

The broader correction, of which wave 3 {+1} is a component, is in the third leg of its course, called wave C {+2} within the initial leg, wave 1 {+3} off of that 2011 peak.

The correction so far has been quite shallow, and in my experience corrections without strong directionality often will extend into a broader stretch made up of side-trending parts. If that turns out to be the case here, then DE's downward journey will be unimpressive.

Odds and Yields

The shallow nature of the correction shows in the historical yields produced by prior bear signals.

The 3rd wave decline that began May 9 has completed three bear signals, two of them successful, with average yield of 1.4% over 33 days. The unsuccessful signal lost 0.7% over 23 days.

The C wave from Jan. 13, which is the parent of that 3rd wave, has had four successful bear signals against six unsuccessful ones. The winning trades on average yielded 1% over 28 days, and the unsuccessful ones lost 2.8% over 26 days.

The win/lose yield spread for the 3rd wave is only 0.7%, and for the C wave, only a negative 1.8%. Neither signifies much in the way of profit potential, without leverage, at least.

The Company

Deere & Co., headquartered in Moline, Illinois, makes the John Deere lines of heavy equipment for uses ranging from agriculture and manufacturing to construction and forestry. The John Deere tractor is an iconic symbol of the early 20th century American farm.

Analysts are far from optimistic about Deere's prospects, collectively coming down at a negative 6% enthusiasm rating.

That's despite high return on equity -- the company reports it at 32%. Perhaps debt running more than double equity has an impact.

Earnings tend to peak each year in the winter quarter, and that quarter was down a bit in 2014 compared to its year-ago counterpart.

The announcement has surprised to the downside only twice in the past year years, both times in 2012. All the other quarters in that period are upside surprises.

The earnings yield is 11.5%, compared to a 2.375% yield on the 10-year U.S. Treasury notes. The dividend yields 3.01% annualized at today's prices.

Growth estimates, when the dividend is taken into account, implies a "fair" price of $96.91, meaning that shares are underpriced by 17.8%. I've marked the "fair" price level on the right-hand chart in purple.

The stock is selling for nine times earnings and at discount to sales. It takes 78 cents in shares to control a dollar in sales.

Institutions own 70% of shares, a lowish level

Deere next publishes earnings on Nov. 26. The stock goes ex-dividend in December for a quarterly payout yielding 60 cents a share.

Liquidity and Volatility

DE on average trades 4.2 million shares per day and supports a moderate selection of option strike prices with open interest running to three and four figures.

The bid/ask spread on front-month at-the-money puts is 4%, compared to a 0.5% for the most-traded symbol on the U.S. markets, the exchange-traded fund SPY.

Implied volatility stands at 20% and has been rising since late August, compared to 16% for the S&P 500 index.

DE's volatility stands at the 78th percentile of the prior decline last August.

Options are pricing in confidence that 68.2% of trades will fall between $73.05 and $82.21 over the next month, for a potential gain or loss of 5.9%, and between $75.43 and $79.83 over the next week. I've marked the one-month range on the right-hand chart in blue.

Contracts today are trading above their five-day average volume, with calls running 42% above average and puts 35% above average.

Decision for My Account

DE is a reasonable shorter-term bear play, although I think the decline lacks legs for the longer term. I intend to open a bear position in DE, structuring it as a short options spread sold for a credit and expiring in the front month.

If downward momentum falters in the half hour before the closing bell, I'll add DE to the Watchlist for later consideration.

-- Tim Bovee, Portland, Oregon, Oct. 8, 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.