AM: AAPL keeps sliding

AM Update

Markets break above 1500 in early trade, will they be able to hold it through the close?  AAPL cannot catch a bid and is under $440.  What will it take to finally get the stock to bounce?

MARKET BEHAVIOR

Stocks opened strong, breaking through the 1500 barrier in early trade, but couldn’t hold those gains and dipped under this key level by mid-morning.  The market found a floor at 1495 and is attempting another assault on 1500.  It will be interesting to see how the market closes and if the pattern of early weakness followed by closing strength is changing.

MARKET SENTIMENT

The S&P500 continues defying weakness in AAPL and broad market investors are unfazed by AAPL’s troubles.  AAPL posted great earnings and is not indicating signs economic weakness; it is simply an isolated story of an over-owned stock.  That is why selling has not spread beyond AAPL.

But how does this unexpected strength affect broad market sentiment?  Some people theorize hedge funds were long AAPL and short the index as a hedge.  They thought AAPL was going to outperform the indexes, but were afraid of economic and political risks taking all stocks, including AAPL down.  In situations like this, they buy AAPL and short the S&P500.  This limits their exposure to the difference between AAPL and the S&P500, allowing them to make money even if AAPL declines, as long as the broad market declines even more.  This is a great way to isolate a single stock’s story from wider economic concerns.

A quick example will better illustrate this concept.  Lets say a major European bank becomes insolvent overnight and requires a high-profile bailout.  All stocks tank on this news, but some more than others.  If AAPL falls 5%, but the S&P500 with its heavy exposure to financials falls 7%, then the hedge fund actually made 2% that day because AAPL outperformed the S&P500.  (-5%) – (-7%) = +2%   This simple idea is the entire reasons hedge funds exist.  They reduce risk by hedging out broad market risk, allowing them to focus exclusively on individual stock stories.  But obviously this only works when they are right about the individual stock story.

Why this matters to the broad market is many of these hedge funds were short the S&P500 as part of their AAPL trade and when they sell out of AAPL, they are also buying back their S&P500 short.  If this really is the case, this is a temporary  lift because short covering is not driven by expectations of higher prices. We need to see other buyers step in to keep this rally going.

TRADING OPPORTUNITIES

Expected Outcome:
The market is taking it’s time at 1500, which is supportive of these levels as long as people are buying for the right reason.  Momentum chasers and short covering represents a small sliver of available money in the market.  While it is large enough to move the markets when they work together, they don’t have staying power to keep prices up by themselves.  This is why we want to see three or four days of support at a level before feeling confident other buyers are also buying these levels.  Today is the second day of trade around 1500 and if we keep this level through Monday and into Tuesday, it proves there is more to this new high than just short covering and we can stay long or add new positions.

Alternate Outcome:
With too many people waiting for the expected pullback, the market continues marching higher, crushing bears and filling traders watching from the sidelines with regret.  These two groups are the ones that keep buying the market and pushing it higher.  With as much selling as we saw between September and November, there are still lost traders holding cash and ready to chase this thing higher.  Breaking through 1505 and closing strong would show this market is still ready to move.

INDIVIDUAL STOCKS

Another bad day for AAPL as it dropped under $440.  If AAPL was a great buy at $550, then it is a screaming deal at $450, but the question any AAPL bull must ask is where are all the buyers?  With continued weakness, new buyers are clearly not interested in this stock at $450 even though a lot of people who swear by the huge intrinsic value.  What this tells us is everyone who believes in AAPL is already fully invested, leaving no one else buy.

I was one of those people until yesterday, but the 10% decline on record earnings invalidated my thesis and in these situations there is nothing left to do but get out and reassess.  AAPL could easily find a floor around $450, but the same thing was said about $550.  The truth is these things go longer and further than anyone expects and clearly that is happening here.

There are two groups of traders watching this stock.  One is value investors attracted to the low P/E and dividend.  The other are holders desperate for a rebound.  The question becomes who will move first.  Value investors, especially those that resisted the temptation to buy AAPL at $500 are an obviously a patient bunch and waiting to see how low this will go.  On the other side are the hopeful owners insisting there is real value in AAPL and it is only a matter of time before it recovers.  At this point it seems far more likely the hopeful crowd will be demoralized by the steady march lower and eventually sell when they just can’t take it anymore.  Once everyone completely hates the stock, it will finally find a bottom and start rallying.  Both FB and NFLX had to go through this cleanse of maximum pessimism before they bottomed.  We should expect the same from AAPL, meaning we need to get rid of all these hopeful owners before this stock can bounce back, and that means lower prices in the near-term.  Apple Inc is a great company, but it will take time for the AAPL stock to work through its supply and demand imbalance.

The best way to trade situations like this is to sell and reassess with a clear head.  If you still believe in the story, buy back in when the price action supports your thesis.  No one is right about every trade and we all lose money, the difference is successful traders admit defeat and move on.

Stay safe