Tim Bovee, Private Trader: PEP: The world turned upside down

Update 10/22/2014: PEP moved above its break-even point as part of a general reversal of the market, and I've exited it, moving it to the Roll Shelf to wait re-entry. In keeping with my normal practice, I won't calculate profit or loss until no more rolls are possible.

Update 10/16/2014: The uptrend that marked PEP's course during the day stalled into a sideways pause as the closing bell neared, well below the prior day's closing price.

That was good enough momentum to meet my needs, and I've opened a bear position structured as a bear call spread, short the $92.50 calls and long the $97.5 calls, bought with a credit and expiring Nov. 16.

Leverage is 6:1, and the breakeven point is $93.50, which is 1.8% above today's opening price. The short options have a 65% chance of expiring profitably out of the money.

PepsiCo Inc. (PEP) has a financial profile that speaks of it as a company that knows how to turn a profit, and analysts are optimistic about its prospects. Yet PepsiCo's stock chart, far from bubbling to the top, has joined the rest of the market in a mournful decline. It is a case of the world turned upside down.

The Chart

PEP hit its post-Recession peak of $96.22 on Oct. 9 and then retreated, in the context of a general decline across the markets.

The final push to the upside completed an uptrend, wave 5 {+3} within an Elliott wave framework, that began in February. The peak stands 120% above its Great Recession low attained in January 2009.

Click on chart to enlarge.

PEP 6 years weekly bars (left), 8 days 5-minute bars (right)

Amid the Chicken Little "the sky is falling!" reporting that has characterized the market declines of the past few weeks, it is important to realized that the PEP decline after the peak has yet to reach the 38.2% Fibonacci retracement level. It is, so far, shallow indeed, giving uncertainty to my assertion that wave 5 {+3} has reached its end.

If wave 5 {+3} is indeed complete, then what has happened so far in the decline is still very early days. If wave 5 {+3} is indeed still underway, then we're seeing a very small counter-trend correction that will soon reverse and carry wave 5 {+3} to new heights. Either scenario remains a possibility under the Elliott wave rules.

I counted the larger degree 5 {+4} as having ended concurrently with the end of wave 5 {+3}. The longest chart available to me is 20 years, and PEP is a very old company with quite a long history that is outside of my view. It could also be a 3rd wave, although 5th seems more likely to me, and my framing reflects that.

The decline after Oct. 9 is very much in its early days. I counted the major movements as being in the base degree, but it could be lower, perhaps much lower.

Odds and Yields

PEP has completed four bear signals since the wave 4 {+3} downside correction began in July 2013. Three were successful, on average yielding 1.6% over 33 days. The unsuccessful trade lost 5% over 50 days. The resulting win/lose yield spread in negative 3.4%, nothing to cheer about.

However, it's worth noting that the bear signals occurred some time ago. If wave 5 {+3} has indeed ended, then prior statistics have little importance to PEP's behavior in the new bear market.

The Company

PepsiCo, headquartered in Purchase, New York, makes a global soft drink and food company whose are products are an homage to everyone's fridge and cupboard: Pepsi (the soda), Fritos, Lays potato chips, Quaker Oats, Doritos, Mountain Dew. Of course, many are also products that anti-obesity crusaders target as being unhealthy, which may account for the the web-site presence of a "Good-for-You Brands" page.

In the discussion that follows, it is important to keep in mind that if, as many say, a market downturn of epic scale has begun, then the world may well have been invented anew -- yesterday's happy verities are of little meaning in the dismal world of a crash, the reasoning goes.

Or not. I've always been suspicious of apocalyptic scenarios, and so, for example, analysts' rosy outlook for PEP's prospects may indeed be right on the mark. They give it, collectively, a 25% enthusiasm rating, but all of those assessments happened prior to the downturn in stock prices.

My own approach is to dial up my skepticism a point or two, but to still pay attention to the tale of the numbers.

PepsiCo reports return on equity of 30%, with debt also at a high level, about equal to equity.

Earnings fell in 2012 compared to 2011 but since have crept upward year by year. The company consistently produces upside earnings surprises.

The earnings yield is 5.01%, compared to 2.15% on 10-year U.S. Treasury notes, and the dividend yield is 2.90% at today's prices.

Growth estimates, combined with the dividend, imply a "fair" price of $49.39, meaning the stock is overpriced by 83%. I've marked the "fair" price on the left-had chart in purple.

The stock is selling for 20 times earnings and also at a premium to sales. It takes $2.05 in shares to control a dollar in sales.

Institutions own 67% of shares.

PepsiCo next publishes earnings on Feb. 11. The stock goes ex-dividend in December for a quarterly payout of 65.5 cents per share.

Liquidity and Volatility

PEP on average trades 6.4 million shares per day and supports a moderate selection of option strike prices spaced $2.50 apart near the money. The front-month at-the-money bid/ask spread on puts is 6.3%, compared to 0.8% on calls on the most-traded symbol in the U.S. markets, the exchange-traded fund SPY.

Implied volatility stands at 21%, compared to 27% on the S&P 500, and has been working its way higher since Aug. 20. Volatility stands at the 100th percentile of the one year range, meaning that options spreads sold for credit are most likely to be successful.

Options are pricing in confidence that 69.2% of trades will fall between $94.86 and $96.06 over the next month, for a potential gain or loss of 6.2%, and between $87.77 and $93.15 over the next week. I've marked the one-year range on the right-hand chart in blue.

Contracts are trading actively toay, with calls running 63% above their five-day average volume, compared to 22% above average for puts.

Decision for My Account

The financials are bullish but that may mean little in a market like today's, driven heavily by macro-economic forces.

I intend to open a bear position in PEP under my rules for shorter-term trades, structured as bear call spreads expiring in the front month, if the price shows downward momentum in the half hour before the closing bell.

Momentum is to the upside as I write. If upward momentum persists, then I'll put PEP on the Watchlist to trade later.

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

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.