Bullish Cross

Bullish Cross Has Moved!

2011-06-15T17:14:00.000-07:00

Bullish Cross has now moved to wordpress. The new site can be found at www.bullishcross.com. This will be the last post here at blogger. We're keeping the blogger site up for a few more days until we complete redirects. Cheers!

www.bullishcross.com

Bullish Cross Professional

2011-06-11T23:29:00.000-07:00

UPDATE: 7:45 PM EST on 6/15/11 -- New Bullish Cross Site is now live. Go to:
www.bullishcross.com

Bullish Cross Pro will is planned to launch next week. I've received countless e-mails from readers over the years, asking me portfolio management questions, when a particular stock will reach a certain level, which options strikes to buy on a particular stock and whether the market is headed higher or lower. While a lot of my writing is focused on Apple -- because it is the most popular stock and most widely read topic out there -- I am an active trader of the SPY and SPY options. I do this for a living and have done so for years. My focus is mostly on very short-term trades and long-term investments. I rarely focus on the intermediate term as I feel there is tremendous clarity in both the short and long term. Far more clarity than what will happen next week or next month.

So in response to many of my readers requests for some advanced investment and trading analysis, I'm going to be starting Bullish Cross Professional. The new site will focus mostly on making as much "monopoly" money as possible. And I'm going to deliver this content with a far more function site from wordpress.

Bullish Cross Pro will be focusing primarily on the following:

1. Advanced Apple Research -- On advanced & detail Apple research analysis for the short, intermediate and long-term.
2. The SPY Model -- A SPY Trading Model designed to double the performance of the S&P 500. The benchmark is to achieve an 80% win-rate with the model.
3. Investment Reports -- There are regularly very significant long-term big trades to be made. I'll be putting together reports on how to capitalize on these big future moves. For example, right there I'm very confident in a potential 500% gain to be had in Apple. Yet, it largely depends on how you capitalize on the investment. Buying the wrong strike price and dates can be catastrophic while buying the write calls can create Fortunes. I'm going to deliver the tools to make the right type of long-term trades. The when to buy, the what to buy, the how to buy, the why to buy, the risks involved and how to capitalize based on particularized risk profile will be discussed at length in these reports. Here's an example of the types of things I'll be getting into. Just in far more detail: how to use spreads to protect profits.

I'll be doing a ton of "hand-holding" throughout the year. There's a solid easy 500% gain to be had in Apple with an imbalanced low level of risk involved. There is such a low risk profile in this trade, that I'm actually pretty shocked that not a whole lot has actually been written about it.

I'll be offering daily and weekly reports on when to put on cover "spreads," when to take off those spreads, when it is more likely for options premiums to deteriorate and when Apple is more or less likely to rally.

I'll also be offering an open forum for questions that I will be proactively answering.

I'll be constantly updating this article and bumping it periodically. Please offer feedback by adding comments or concerns. If there's something that you think I can offer that I haven't mentioned, please feel free to give ideas.

Pricing Model: $49.99 (early adopters)
I've been receiving a lot of requests and some strong feedback from people through private e-mail and on private forums. The vast majority of Bullish Cross Pro will be available at a monthly rate of $49.99. I've decided on pricing model that would not exclude smaller portfolios from being able to capitalize on the material. I feel that the SPY model is worth far more than that by itself as most investors using the more are likely to recoup the entire expense of the subscription in a very small fraction of the trading month. That is not considering the other actionable material on the site.

I will also be expanding on the information offered over time. At no additional cost to early subscribers. The pricing is likely to increase over time based on the offering. Yet, I plan to keep early adopters grandfathered in at their $49.99 rate as long as they continue their subscription. Moreover, Bullish Cross will eventually be merging with other writers over the next year or so and BC early adopters will continue at their early adopters rate.

On top of the monthly subscription, I'll be offering investment reports ala carte. What you'll get with the investment reports, is a separate tiered subscription that grants access to not only the investment report, but to any follow-up or updates to the report. It's going to simply be a separate tiered membership. It's going to be difficult to grant a discount to monthly subscribers. Though it will likely be very workable to get a discount on this tier to yearly subscribers. So I going to keep those reports as cheap as possible. It's a one-time fee and will grant access to on-going material.

Release Date
Bullish Cross Pro is planning to go live sometime within the course of the next week. I'll be updating periodically as the site continues in development. Stay tuned.

Apple's Valuation: The One Article Every Investor Should Read

2011-06-07T08:17:00.000-07:00

This will be one of the most important articles I'll ever write on Apple's (AAPL) valuation, and it's the one piece that every individual investor should read. There seems to be a tremendous amount of confusion among market participants as to which valuation metrics actually matter in assessing the present and future value of stock prices in general and Apple's in particular. I hope this article will help correct a lot of these very critical mistakes that many individual investors tend to make when attempting to forecast Apple's future value. This applies to nearly all tech stocks.

I'll come right out from the get-go and say that the vast majority of mistakes made by investors stems largely from their unwavering stubbornness to use non-ubiquitous valuation metrics in order to justify some theoretical or abstract future value that the broader market simply does not accept.

I have repeatedly stated that the only valuation metric that matters is the one the collection of fund managers care about. Everything else in between is not only counter-productive, but designed to trap investors into an investment thesis based on a theoretical and flawed future value that simply does not exist.

The two biggest theoretical valuation models that have the highest likelihood to mislead investors are the Price-to-Earnings Ratio x-Cash (P/E x-cash) and the Price-to-Free-Cash-Flow (P/FCF). I'm not saying that these two valuation ratios are inherently evil or bad valuation ratios, but what I am saying is that these two are by far the most highly misused metrics. Apple's cash and cash flow play a very significant role in its valuation, just not in the way that 95% of individual investors think that it does. (read more)

Bullish Cross Professional Analysis
Forecasting price targets for Apple requires an ability to predict two entirely separate variables that fall within two entirely different disciplines -- (1) Apple's earnings per share at some point x in the future and (2) Apple's trailing P/E ratio at that same point in time.

The first variable -- predicting future EPS -- falls under the discipline of accounting, financial statement analysis, thought clarity and intuition. It is both an art and a science to be able to predict what Apple or any company will earn in the future and there aren't many people who have been able to do so with any level of consistency. Being able to predict the earnings outlook, however, is only one part of the equation.

The other even more important variable is being able to determine what Apple's trailing P/E ratio will be at some point 'x' in the future. One can miss their EPS forecast by $1.00 or even $2.00 ($0.50 a quarter which is a big miss) and that would have a significantly lower impact on forecasted future value than failing to accurately predict Apple's P/E ratio by a factor of even 1. There's a huge difference between Apple trading at a 14 P/E ratio at the end of fiscal 2012 and Apple trading at a 15 P/E ratio at that time.

I will be spending a considerable amount of analysis on projecting Apple's P/E ratio at Bullish Cross Pro over the next few weeks. I will also be providing an in-depth analysis on how to best capitalize on the obvious long-term direction of Apple's stock price so as to maximize profits while reducing risk exposure to a negligible rate. Putting on spreads at the right times can lead to an eventual zero-sum risk exposure by reducing cost basis down to zero.

Apple to $400 by July

2011-05-31T14:50:00.001-07:00

In early September, though Apple (AAPL) had bounced between $230 and $270 all summer, I was able to conclude that the early September Apple momentum was "for real," that Apple would make significant new highs above its $278 June closing and that the stock would reach $300 a share in just four weeks time - that was $50 above where the stock was trading when I made the prediction for Apple $300 by October.

That was not an easy call to make considering the fact that Apple had rallied and sold off numerous times between April and September - nearly six months - making it difficult to tell whether that big swing from $235 to $250 was real and not just another short-term rally before another bust.

I also mentioned in the article that Apple would reach $350 by January. Again this was at a time when Apple was range-bound for over six months. Interestingly enough, we're in the same exact situation in this current market. Apple has been range-bound for nearly seven months now, trading between $320 and $365.

Moreover, in today's session, Apple saw significant momentum as the stock rallied over 2.5% heading into the close of trading. It was nothing but buying all day long. Thus, the big question on the minds of investors is this: Is this rally for real or will Apple simply fall apart after a few days of rallying ahead of the WWDC? Is this just another short-term buy the rumor and sell the news like we saw in April earnings? Can this momentum carry Apple to fresh all-time highs? (read more).

Apple's Cash to Exceed $300 billion by 2015

2011-05-31T02:36:00.000-07:00

Dear Bullish Cross readers. Just wanted to let you know that Apple will probably end 2011 with $81 billion in cash. It will end 2012 with $120 billion in cash and be producing roughly $12 billion in cash flow per quarter by October 2012. If Apple grew at 0.00% in fiscal 2013, it would still end the year with roughly $170 billion in cash or just about $190 in cash for every single share in the company.

If it then carried that 2013 0.00% growth rate into 2014, the company would have $230 billion in cash or just about $250 in cash per share. 2015 it would have $300 billion in cash or $330 in cash per share. Again, that assumes 0.00% growth for 2013, 2014, and 2015. So if Apple grows 0.00%, then by 2015, it will have more cash per share than the stock is trading at today.

Let me let you in on a little secret. Apple is trading at $78 right now. This is the financial crisis. This is your second opportunity to capitalize on that run that a lot of you might have missed when Apple was sitting at $78. There is no chance that Wall Street is going to allow Apple to trade below it's cash value. Next year is going to be one monumental year for Apple and that's largely due to the fact that it's going to flex its cash flow muscles.

While the whole world already discusses Apple's massive cash holding, they have absolutely no clue just how major that cash flow is going to actually be. If Apple is trading anywhere close to where it's trading today 2-years from now, it would be able to take itself private with very little outside help. Just something to think about as wall street debates its daily moronic bullshit about whether there's an iPhone delay, whether Steve Jobs is coming back or whether iPad production is hurt as a result of some explosion in china. I'll be devoting an article to this issue after the WWDC. I'll get you the details next week. For now, please see my iPhone revenue estimates, iPad revenue estimates and Macintosh revenue estimates for 2012 as the main driver of my expectations for $150 billion in total revenue.

An Early Look at Apple's Fiscal Q3 Earnings

2011-05-31T01:19:00.000-07:00

The big story this quarter will undoubtedly be Apple's (AAPL) unprecedented $2.5 billion revenue beat of analyst expectations when it reports its fiscal Q3 earnings results this July. See my earlier article detailing every aspect of Apple's fiscal Q3 revenue here.

Another big story this quarter will likely be focused on Apple's highly depressed valuation and P/E ratio. If Apple continues to trade sideways when it reports earnings in July, its P/E ratio will fall into the 13's which is the lowest in 10-years and far below the financial crisis lows if one considers Apple's unamended earnings at the time.

A consensus poll of Wall Street analysts are expecting Apple to report $5.61 in earnings per share on approximately $24.5 billion in revenue for fiscal Q3. Yet, my analysis by contrast, suggests Apple will report something closer to $6.76 in EPS on $27.053 billion in revenue. I expect revenue to be largely driven by explosive sales of Apple's iPad, iPhone and Macintosh computer.

Last quarter, out of 48 analysts polled, I came in 2nd place behind Jeff Fosberg of the Apple Finance Board in most accurately predicting Apple's revenue and earnings with a cumulatively margin of error of only 1.46% according to Fortune's Philip Elmer-DeWitt (see here). In fiscal Q1 2011, I came in 5th out of 41 analysts polled by Fortune with a 3% error rate. And in fiscal Q4 2010, I came in 5th out of 38 analysts polled by Fortune with a mere 1.87% error on the quarter.

Thus, if Apple reports something more in-line with my expectations, this would represent yet another 92.6% growth rate in earnings per share (EPS), and a 72.3% growth rate on the top-line. (read more).

Apple to Report an Unprecedented $2.5 billion top-line beat in Fiscal Q3

2011-05-31T00:40:00.000-07:00

While Wall Street continues its 7-month bear clawing of Apple's (AAPL) stock price, the company is about to report the largest top-line beat in its 35-year history -- and quite possibly one of the biggest top-line beats in the market's history. Apple's stock price has been far underperforming the NASDAQ, S&P and Dow Industrials over the past 8 months, despite repeatedly posting outrageously high growth-rates.

Last quarter, for instance, Apple's earnings per share grew 92%, higher than the vast majority of stocks trading in the S&P 500. Yet, in spite of this ridiculously strong growth for a company of Apple's size, the stock's P/E ratio continues to fall quite dramatically due to the company's simultaneous explosive earnings and the underlying stock's underperformance. In fact, if Apple continues its sideways trading even after it reports earnings in July, Apple's P/E ratio will fall to the lowest level in nearly 10-years -- eclipsing the lows of the financial crisis. (read more).

2011-2012 Macintosh Sales Estimates

2011-05-30T14:01:00.000-07:00

While forecasting sales estimates for Apple's (AAPL) iPhone and iPad presents with a variety of difficulties, projecting Macintosh sales for 2011 and 2012 isn't all that hard. Macintosh sales have been on a nice, consistent upward trajectory and regularly observes an easily recognizable pattern of both seasonal and sequential growth trends. You can find my 2011 iPhone estimates here, my 2012 iPhone estimates here and my 18-month outlook on iPads here.

If there is one projection that I've consistently nailed over the past several years, it's been in forecasting Macintosh sales growth. The reason Macintosh sales is relatively easier to predict is because there's only one quarter where there is a consistent sequential decline. And that is in Apple's fiscal Q2. Other than fiscal Q2, each quarter's Macintosh sales is higher than the previous quarter.

2009 was the only exception to this seasonal trend out of the past 7-years. And that was largely due to the fact that we were in the middle of a financial crisis during the quarters in question. Still, even then there was the same recognizable pattern of growth where Q2 was the lightest quarter of the year.

Here's how the Macintosh seasonal cycle unfolds: What we tend to see is a strong fiscal Q1 follow through on the back of a massive record spike in sales during Apple's back-to-school shopping season (fiscal Q4). Almost every year for the past 6-7 fiscal years, fiscal Q4 has always represented a massive spike in sales over the previous three quarters. (read more).

2011-2012 iPad Sales Estimates

2011-05-27T13:02:00.000-07:00

By far the most difficult, uncertain and highly theoretical forecast to make regarding Apple's (AAPL) financials is figuring out what the company will record in terms of iPad sales. Not only do we have very little historical data upon which to base forward estimates, iPad sales are simply all over the place.

This makes it extraordinarily difficult to tell exactly what the seasonal trend looks like with the device and whether there is any meaningful seasonality to begin with. Is the iPad more like the iPod where there's a very noticeable massive seasonal spike in sales during the holiday shopping season or is the iPad more like the iPhone where sales don't seem to follow any sort of significant seasonal trend? (read more).

2012: The 115 Million iPhone Year

2011-05-26T12:40:00.000-07:00

In a piece I published yesterday at Seeking Alpha, I laid out two different forecasts for 2011 iPhone sales. One scenario is based on the assumption that the iPhone 5 is unveiled and launched for sale in June, and the other scenario is based on the assumption that the iPhone 5 released for sale in September.

The current overwhelming consensus suggests that the iPhone will in fact be delayed until September, but just in case Apple (AAPL) decides to pull off a surprise launch at the worldwide developers conference held in June, it's wise to lay out two different forecasts until we know for sure. I should point out, however, there is some evidence that may suggest an iPhone launch is coming in june.

As I pointed out in yesterday's article, the iPhone delay could cost Apple more than $4.5 billion in revenue during in its fiscal Q4, which will be to the benefit of one or more quarters in fiscal 2012. (read more).

Zaky: 2011 iPhone Sales Estimate

2011-05-25T20:50:00.000-07:00

Phone sales have accounted for nearly half of Apple's (AAPL) revenue over the past few years, and it's enormously important to the company and its investors. Thus a big part of being able to forecast Apple's fiscal 2011-2012 revenue and earnings largely depends on one's ability to grasp where iPhone sales are likely headed in the future.

To get an idea of just how important the iPhone is to Apple's financial well-being, Apple produces about $660 million in revenue for every 1 million devices sold world-wide. The iPhone also carries extraordinarily favorable gross margins and excellent average selling prices. The iPhone has been out for nearly 5 years now, and Apple still maintains a $660 ASP on the device.

One can see how Wall Street analysts consistently miss on their earnings forecasts. Missing iPhone sales by even 1 million units can wreak havoc one's estimates. In Q2 2011, for example, Apple reported unit sales of 18.65 million iPhones which was more than 2 million units -- or $1.32 billion -- above the Street's expectations (read more).

Apple's Stock at a Critical Juncture

2011-05-22T13:11:00.000-07:00

Generally speaking, I don't believe there's much a place for technical analysis when it comes to long-term investments. Yet, given the current unfortunate circumstance in which Apple (AAPL) investors find themselves, I think it is extraordinarily important in this instance that investors be aware of a raging battle taking place on Wall Street regarding the pricing of Apple.

As most investor already know, Apple has been struggling to move higher since we've entered the new year. The stock is trading near levels it reached back in October of 2010, and has been significantly underperforming the NASDAQ-100, NASDAQ, S&P 500 and DJIA since that time. Apple's P/E ratio has fallen to levels unseen since the days of the financial crisis and despite posting explosive 92% earnings growth, the stock has more or less been the biggest bust of 2011.

A lot of investors want to know what is going on, and why Apple is struggling despite its extraordinary fundamentals. On a daily basis, I get e-mails asking me if Apple is headed lower and when the stock might bottom. I believe having a clear understanding of both the fundamental and technical side of the equation can help set parameters on where the stock is probably headed in the short, intermediate and long-term. (read more)

News: The iPhone 5 is coming in June (Not Delayed)

2011-05-18T10:25:00.000-07:00

A few weeks ago, CNBC contributor Herb Greenberg argued on national television that Apple (AAPL) should stop offering quarterly guidance due to the fact that Apple’s management is far too conservative to be helpful. While it’s obvious to most analysts that conservatism has very little to do with whether a company’s guidance is helpful -- consistency is the far more relevant issue -- Herb Greenberg is about to learn why a careful analysis of Apple’s guidance is important in more ways than one.

First of all, good guidance analysis is almost always helpful to investor-analysts who have consistently outperformed Wall Street in accurately predicting Apple’s quarterly earnings. Yet, every so often, Apple’s guidance can also shed light on something very significant beyond the company’s earnings. Take Apple’s recently reported fiscal Q2, for example. In the conference call, Apple’s CFO Peter Oppenheimer, stated very briefly among several other statements, “We expect OpEx [operating expenses] to be about $2.5 billion, including about $255 million related to stock-based compensation expense.”

To most people, this may seem to be a relatively benign and largely mundane statement. Something Herb Greenberg might find to be unimportant or trivial. Yet, to those with a more keen eye, Peter Oppenheimer might as well have just said, “Despite what you might hear on Wall Street, we expect the iPhone 5 to be released in late June or early July as planned.” (read more).

Apple's P/E Ratio Falls to Lowest Level Since Financial Crisis Despite 92% Earnings Growth

2011-05-13T14:54:00.001-07:00

While Apple's (AAPL) revenue and earnings have absolutely skyrocketed over the past few quarters -- it reported 92% growth in its recently ended fiscal Q2 alone --its stock price has barely advanced since reaching $320 in late October. Yesterday, the stock closed at $346.57, or 8.6% higher than where it was trading at over 7 months ago.

The NASDAQ-100 (QQQ), by contrast, has rallied 18.22% over the same time period. The stock hasn't even been able to outperform the NASDAQ-100 despite trading at the cheapest relative valuation of the group and posting almost the highest net income growth rate surpassed by only a handful of stocks with lofty valuations. Even the broader S&P 500 (SPY) has outperformed Apple since October, posting 16.2% gains in the period.

Apple's stock price has simply been unable to keep pace with its explosive 90% growth in earnings. As a result, Apple's P/E ratio has gradually fallen over the past year to the point that the stock is now trading at the lowest valuation we've seen since the depths of the financial crisis -- the stock currently trades at a mere 16.5 trailing P/E ratio. In fact, between April and June of 2009 -- just after the market bottomed -- Apple was trading at a higher trailing P/E ratio (16.93) than it does today...(read more)

Why Apple's Guidance Is Still Important

2011-04-25T18:04:00.000-07:00

On Thursday afternoon, CNBC's Herb Greenberg argued that because Apple (AAPL) always sandbags its guidance by beating EPS estimates by an average of 27% over the last several years, Apple shouldn't bother offering guidance anymore. He quotes Bernstein Research analyst Toni Sacconagi as saying, "Apple has historically been so conservative [with its guidance] as not to be helpful."

Herb Greenberg says that Toni Sacconaghi is an Apple super-bull, which simply just isn't the case. While he may have a buy rating on the stock, he has actually been historically somewhat bearish on the stock; see here. He was the analyst known to raise the frivolous "missing iPhones debate" a few years ago which led to across the board bearishness in the stock and misled a lot of analysts and members of the press into cutting their earnings expectations; this was later shown to be a huge mistake when earnings clearly demonstrated that the concern was utter nonsense. (read the full article here).

Apple Q2 2011 Earnings Preview

2011-04-20T03:13:00.000-07:00

I've published my earnings preview exclusively at Seeking Alpha. You can read the article here.

Are Apple Shares Dirt Cheap?

2011-04-19T13:31:00.001-07:00

In light of Apple's fiscal Q2 earnings report out after the bell tomorrow, I put a piece together for Fortune showing just how cheap Apple is getting based on it's cash growth and P/E ratio. Here's a snippet from the article:

"If the stock doesn't move up at all or moves down on earnings, Apple's trailing P/E ratio will drop below 15.8 -- the lowest level since the market's March 2009 lows. This is exactly what makes tomorrow's earnings one for the books. Either Apple's stock will have to jump by more than $55 to keep its already miserable P/E ratio in tact, or the stock will likely fall to its lowest valuation since the depths of the financial crisis." Read more here.

The iPhone v. Android Platform War

2011-04-11T11:24:00.000-07:00

Last week, Henry Blodget at Business Insider published two pieces analyzing the recent smart-phone platform market-share results released by ComScore. You can read his two articles here and here. Today I published a response to his thesis that Apple investors should be worried about Android's recent gains in the U.S. market at Fortune.com. See here.

Apple Q2 2011 Estimates

2011-04-08T11:22:00.000-07:00

The table below contains my estimates for Apple's second fiscal quarter ended March 2011. Like every other quarter of the past several years, Apple will once again blow out expectations when it reports later this month. For a more in-depth analysis, I'll be publishing an earnings preview at Seeking Alpha. Stay tuned.

Is a correction coming?

2011-02-15T11:39:00.000-08:00

The market is up nearly every day since mid-November. Is this market due for a correction or can this rally continue for another 5-months without a pull-back? A recent study suggests a continuation of this rally is very possible.

In 90% of cases, a correction has taken place this week. To see the study and my analysis of the material, you can read the full article here at Seeking Alpha. I've decided to make Bullish Cross an aggregator of my personal content which will be published at various publications. So most of my writing will be found off site.

Apple to beat top-line Expectations by $2 Billion for Q1 2011

2011-01-16T22:10:00.000-08:00

As investors continue to mull-over the consequences of Steve Jobs' abrupt and immediate health-related leave of absences from the company, Apple will be posting its fiscal first quarter results after the bell this afternoon.

The huge story this quarter will undoubtedly be the gigantic $2 billion top-line beat that Apple is likely to dish out when it releases results. This will prove once again how analysts continue to under-estimate just how explosive Apple's growth really is.

Wall street Analysts polled by Thomson Reuters expect Apple to post $5.38 in earnings per share (EPS) on approximately $24.38 billion in revenue. Yet, bloggers and unaffiliated analysts who tend to almost always outperform wall street analysts are looking for significantly stronger numbers out of the company. The spread between analysts and bloggers isn't always necessarily very wide, but when it is, Apple tends to smash all expectations.

Bloggers are looking for Apple to post $6.32 in earnings per share (EPS) on approximately $26.4 billion in revenue. This according to a poll recently taken by Philip Elmer-DeWitt at Fortune. As anyone can see, the bloggers are looking for Apple to beat on the top-line by over $2 billion.

Now while I don't doubt this report is likely to be well received by investors and Apple will probably pop on the report in after-hours despite Jobs' health related leave of absence, I think the stock is likely to sell-off a bit within a day or two after its report. It has tended to be almost always prudent to take profits whenever Apple has run-up big ahead of its earnings report and then gaps-up big in the following trading session. The tendency has been to see Apple trade sideways to down from either its opening price after earnings or the following few trading session.

The Steve Jobs news won't help matters very much either. In fact, I think it's even possible that Apple could be immediately sold-off on great earnings given the humongous run it has had since August. The stock is up over 50% in just 6 months time. So if Apple trades very poorly into the close, I wouldn't be surprised to see further downside on the earnings release. The chart below shows how Apple has tended trade following its past quarterly earnings results.

Also the broader market is extremely over-extended and it is now getting increasingly likely that we'll see a 10% or so correction within the next few weeks. Whenever the S&P 500 trades 10% above its 200-day moving average, the broader market tends to see some sort of a pull-back which might present opportunities for those waiting to jump into Apple.

For those who wish to take advantage of hedging strategies or reduce earnings volatility, please refer to my article on how to protect Apple profits ahead of its earnings releases.

Disclosure: No position in Apple.

Near-Term Top in the Markets Likely in on FOMC Day

2010-12-14T12:33:00.000-08:00

Today probably marks a top of some sort in the markets. If not an intermediate-term top, then a near term top. Expect to see some selling pressure over the next couple of weeks. Yet, if the market does grind higher, it will be on extraordinarily weak volume as all buying interest has completely dried up and will lead to an almost certain big sell-off in January.

Thus, if we don't see a steep sell-off over the coming weeks, expect a major May-type sell-off in January. Right now its simply not safe to be in the markets. I think Apple has put in its top for the year and it will likely see major selling pressure in January. Tread carefully here as we're at bearish extremes not seen since the top in April. This coupled with the fact that buying interest has completely dried up sets the market up for a major sell-off any day now.

Disclosure: Short the QQQQ.

December Rally Update

2010-12-06T09:25:00.000-08:00

The day before the market bottomed last week, I noted in my previous post that the 3-week sell-off following the release of QE2 was coming to and end and that we would rally to new highs. That Apple would see all time highs by this week and that we would likely see significant inflows into equities over the next several weeks.

As an update to that assessment I wanted to point out that a lot of signs are pointing to a weak Tuesday, Wednesday and maybe Thursday. We could have a relatively steep sell-off this week. Yet, that sell-off, if it does happen, is a major buying opportunity. It's a buyable dip.

The CBOE put-to-call ratio ($CPC), $VIX and QQQQ channel trend are all signaling lower closes ahead. Yet, this all goes out the window if the S&P 500 breaks out to new highs, if the $VIX closes in the red or if the $CPC closes above 80. The signals are invalidated on any of these situations. At this point, its worth mentioning as a concern.

The strategy I'm employing going into the next several days is buying at the lower trend line on the QQQQ or on a breakout above $54. We are sitting at an uncertain range right here. Waiting for a breakout or sell-off to add to my long position.

Post QE2 Sell-Off is at an End

2010-11-29T19:20:00.000-08:00

This sell-off following the release of QE2 over the past several weeks is coming to an end. There's a good chance that today (Monday, November 29, 2010) was the low of this sell-off, and that we're about to go into full-fledged melt-up rally mode again. Expect to see a breakout to new highs before the close of the year. I'm setting a target of 1265 on the S&P 500 for 2010.

Even if we see incremental new lows over the next few days, the absolute bottom will be in on the employment report which generally has the tendency to mark the start of a new trend in the market. Expect significant inflows into U.S. equities as funds flee global equities in favor of domestic stocks. Funds will continue to chase performance into year end and expect significant QE2 Pomo dollars to drive stock prices way higher as fund managers assume more risk heading into year end.

While sovereign debt concerns in Europe might continue over the coming weeks, I expect U.S. equities will be the biggest beneficiary of the continued outflows from European equities as global equity funds continue to take advantage of a weaker dollar through the Euro carry trade. Expect Apple to see new all-time highs no later than next week as technology stocks lead the market higher into year-end. I still expect to see a significant melt-up rally that will continue for the majority of 2011.

Disclosure: Long January QQQQ calls.

Huge Rally Coming to Equities Next Year

2010-11-03T10:37:00.000-07:00

This is indeed the most important week of the year, and maybe even the most important week of the entire business cycle. Whatever happens, there will be a huge opportunity to make some significant gains in 2011. Either the market will breakout today and continue to run until year end, or we'll get our much needed correction after rallying nearly 20% in a little over 2 months on the NASDAQ.

Market participants are looking at two numbers today which will give us the direction for the intermediate term. If the S&P 500 breaks above 1,200 today and closes above that mark, then we're headed much much higher from here. Maybe even to 1,300 before year end. If the S&P closes substantially below 1179, then we're probably at the eve of correction. It doesn't matter what happens today because there will be opportunity to capitalize on the directional move in the market.

Yet that isn't even the most important aspect of this week. Whatever happens--correction or continuation of the melt-up bubble--one thing is very clear. 2011 is going to be one huge blowout year for equities. If we get a correction, then it will be one of the best buying opportunities since the March 2009 lows. However, if the S&P breaks above 1230 and the QQQQ breaks above $55, then we're going to see some massive moves in equities.

In fact, break above $55 on the QQQQ and we'll see Apple $500, Google $800, Amazon $250, Research in Motion $120, Microsoft $40, IBM $200 and Intel $33 sometime within the next 18 months. A break above $55 on the QQQQ will send technology stocks skyrocketing as the QQQQ will see absolutely no significant long-term resistance all the way to $83.

Notice these price targets are not based on fundamentals but on a theory of asset inflation. We're going to get a new mini-tech bubble much like what we saw in 1999-2000. Just because things might become overvalued, doesn't mean we can't go much much higher. A significant break above $55 on the QQQQ suggests a 70% move in Apple.

Disclosure: On the sidelines awaiting directional clarity.

Market Thrust Headlong into the Maelstrom of Correction

2010-10-19T15:44:00.000-07:00

UPDATE 3 (5/25/10): The market is once again struggling to close above the opening print. There's two things to look out for over the next 40 minutes. First, investors should see if the market can close above its opening price. If it can't, then it's bearish.

The second, and more important, thing investors should observe is whether the VIX closes in the red. In 8 out of the 9 last cases where both the S&P 500 and VIX closed both in the green, the market was down the following trading session. What's concerning is that both the front month and 3-month VIX are up today. So people are bidding up not only near term volatility, but intermediate term volatility ($VXV).

UPDATE 2 (5/21/10): The market reversed yet again today. That's like 8-9 reversals now compared to the 2-3 that normally precedes a big correction. This notwithstanding, we're going up tomorrow. The market has been showing some astonishing gains on Fridays, so why should this Friday be any different? Oh yeah, we also have a POMO coming tomorrow and the market has essentially been up every single day the fed intervenes in the markets. So check my track record since October 19. I called up big yesterday, mild up day for today and for tomorrow I expect we could be up for the day. Yet, Monday should be down quite significantly. Maybe on the order of 200 dow points.

UPDATE 1 (5/20/10): Notice how the market is up big today exactly as I noted in this article yesterday. Now for tomorrow, what tends to happen is 1 of 2 things. Either we have a mild up day (no more than 50 up) or we're down very big (-150 or more). This is exactly why I said don't get too complacent with this big up move today. I'll update again tomorrow.

October 19, 2010 - Now that Apple earnings have come and gone, the market has likely commenced its topping process and investors should expect choppy sessions ahead. Tops come in two forms. Markets either set a conclusive top which is followed by 10-15 sessions of straight down (much like we saw in late June) or they tend to consolidate through a series of huge up and down moves (like we saw in January, April and July).

Given the velocity of this move up, the bulls will simply not give up that easily. This 170-point whacking will be swiftly answered by the bulls. But don't get too complacent or think that we're headed much higher from here as we limp into the mid-term elections and QE2. We'll see a good fight from the bulls, much like we did for 10-sessions before topping in late April, but the bears will win this battle and we'll get a much needed correction - its healthy for the markets after a move like we've had.

Yet, unlike these past few corrections since April, this correction could very likely present with a good buying opportunity. In fact, I think that this correction could be the last we'll see in a very long time. What I suspect will happen is that we'll see a very severe sell-off followed by another 2009-type leg up in the markets.

There's a very large number of reasons why we're set to sell-off. But seeing as how the vast majority (>99%) of market participants simply misconstrue the difference between the weight of evidence and conclusion, I won't be surprised to see the idiocy that usually comes with the writing of these types of articles.

Yet, because I like to take on tasks which are obviously futile, I'll give it a shot nonetheless. Here are the reasons why we're probably going to see a significant sell-off very shortly if we haven't started already. The vast majority of these reasons come by way of Cobra's Market View. I'm just summarizing what he has already said over the past few weeks. But the evidence has now gotten overwhelmingly bearish.

1. Commercial Hedges are far too net short the NASDAQ-100. Whenever commercial traders get this short the NDX, there is a very high likelihood for a correction. And seeing as how the NASDAQ led this move higher, as goes the NASDAQ-100 so goes the market. Commercial hedgers took record short positions in October. More than double what we saw ahead of the 2008 top. This chart is curtesy of SentimentTrader and annotations are curtesy of Cobra's Market View. See here.

2. The AAII Bull Ratio (4-week average) is way too high. There's a very strong correlation between market tops and bullish sentiment getting over-extended. Again, this chart is curtesy of SentimentTrader and thanks for Cobra's Market View for both the find and the annotations. Notice the strong correlation between market tops and extreme levels in AAII (click).

3. Too many Reversals. Peter (Yong) Pan, the author of Cobra's Market View, noticed a strong correlation between market tops and multiple reversal days. We've had far too many reversal days now. In fact, this is the highest number of reversal days recorded for any rally without a correction since 2008. Good game? We've had 4 actual bearish reversals into the red and 8 or more reversals that while didn't close red, were deep reversals nonetheless. Again, notice the correlation between tops and reversals. Curtesy of Cobra's Market View. If there's one site I fully recommend, its Cobra's Market View.

4. Institutional selling divergence from the market getting high. Though the market continued to rise through October, institutional selling starting to pick up. This also has a high correlation to tops in the market. Again, thanks Cobra's Market View for the chart. See here.

5. Vix at 1-Month Low in October. Here's a table outlining the S&P 500's performance in the 2-3 weeks after the Vix hits a one-month low in the month of October. The odds highly favor the bears under these circumstances. See here.

6. Up Big on Off-Season. Whenever the S&P 500 is up in the off-earnings season, the tendency has been to sell the market during earnings season. The last three times the S&P 500 has been up 5% or more in the off-season, the average sell-off during earnings season has been about 5%. See here.

7. ISEE Index & ETF Only hitting too many extremes. There's also a very high correlation to tops in the market whenever, on multiple days, we see a reading of over 100 on the call-put ratio on the indices (Index & ETF Only ISEE). Whenever we start to see a lot of hedging or outright shorting near the end of a big rally like we've had, its been a pretty big sign that we're headed lower. This chart is curtesy of Cobra's Market View and the International Securities Exchange. Note the high correlation between tops in the market, and multiple days of high ISEE index readings.

8. Broken Rising Wedge. We have a confirmed broken rising wedge on the SPY as of today. That is pretty bearish. Rising wedges are by their nature bearish formations to begin with as nearly 70% of the cases usually end will a breakout to the downside.

9. Lower Trend Line Failure. The Dow Jones Industrial Average (DJIA) has broken its lower trend line today. The DJIA tends to lead the market. Today's failure is just another piece of evidence suggesting we're headed lower.

10. Apple Weakening. Now for the grand finale. Apple is the unequivocal market leader and was the market leader in this huge September rally. Now just because Apple sold off on earnings doesn't mean that this particular move up is over. In fact, there are cases where Apple has reversed out of its sell-off to make new highs days later. But those cases are very few. If Apple closes under $300 a share, it will be a very bad sign for this market, and particularly for the QQQQ (given the fact that it's nearly 20% of the weighting of the NASDAQ-100).

There's some strong evidence that Apple is very overextended. You can see the arguments making a case for an intermediate term top in Apple (2-3 months) here.

Now for the big disclaimer. This is the part that 99% of the people who are in the financial industry have difficulty comprehending. Just because the evidence overwhelmingly favors the bear case, just because the correlations are very high that we've either topped or are approaching a top to this rally, just because commercial traders are super net short, DOESN'T MEAN THAT WE ARE GOING TO SELL OFF WITH 100% CERTAINTY!

THIS IS JUST EVIDENCE! Evidence needs to be weighted against other considerations. Right now the balance of the evidence supports a conclusion that the market is about to undergo a correction. If the market doesn't happen to sell-off from here, it doesn't make the conclusion or the evidence any less valid. Just because an indicator doesn't work one time, doesn't mean that the entire sample of cases becomes invalidated.

Most of the indicators above have such a high level of reliability that any one of them individually can suggest we're topping when at extremes. We have several indicators at extremes.

Yet, in the end, what moves this market higher is a willing buyer and a willing seller. If the supply of buyers continues to outstrip the supply of sellers, then despite the hard evidence, we're going higher. But the only common sense thing for traders and investors to do is to bet with the probability. Right now, the odds favor the bears. That's all that can be said here.

But given that QE2 is right around the corner, given that the mid-term elections are right around the corner, and given that Ben Bernanke has made it painfully obvious that the Federal Reserve will do everything in its power to backstop the equities market anything is possible. If Bernanke wants it, we can rally 100 straight days from here with every single indicator in the market hitting extremes.

One more thing...These were just a selection of some of the indicators suggesting that we're at extreme levels. Visit Cobra's Market View to get a more comprehensive look at some other major indicators not discussed here. There are several other equally important indicators discussed at Peter's blog.

Good luck!

Disclosure: Net long Apple with a fully hedged call-spread. Heavy puts on the QQQQ. The information contained in this blog is not to be taken as either an investment or trading recommendation, and serious traders or investors should consult with their own professional financial advisors before acting on any thoughts expressed in this publication. This blog is for intellectual and educational purposes only.

Apple: Q4 2010 Earnings Preview

2010-10-17T16:40:00.001-07:00

As the market grinds higher in anticipation of QE2, all eyes are on Apple as the company sets to report fiscal Q4 earnings on Monday after the bell. Analysts polled by Thomson Reuters expect Apple to report approximately $4.06 in EPS on about $18.86 billion in revenue. Yet, according to a more recent poll taken by Fortune's Philip Elmer-DeWitt, professional analysts are looking for Apple to earn closer to $4.11 in EPS on $18.95 billion in revenue. The "professionals" expect revenue to be driven primarily by sales of 11.38 million iPhones, 9.54 million iPods, 3.78 million macs and 4.73 million iPads.

Yet, for those not living under a rock for the past three years, the more important and reliable estimates come by way of Philip Elmer-DeWitt's "Unaffiliated Analysts" as we're called. According to a collection of bloggers who almost always outperform professional Wall Street analysts, investors should expect to see Apple report about $4.73 in EPS on approximately $20.37 billion in revenue. The general consensus among the unaffiliated blogger-analysts, revenue will be driven by sales of 12 million iPhones, 9.74 million iPods, 4.01 million macs and 5.52 million iPads.

Based on my earnings model (see here), my estimates this quarter fall on the lower end of the unaffiliated analyst estimates. My model is looking for Apple to report earnings of about $4.65 in EPS on about $19.6 billion in revenue. I'm looking for Apple to report sales of 12 million iPhones, 3.92 million macs, 10 million iPods and 5 million iPads. Yet, despite my earnings model giving a slightly more conservative outlook for Apple's fiscal Q4, I think its very important that a certain level of deference should be afforded to the general unaffiliated analyst consensus. Investors should consider the reports and earnings models of each of the unaffiliated analysts. For a very comprehensive list of the majority of Wall Street and Unaffiliated Analyst earnings outlook, please see Philip Elmer-DeWitt's earnings preview at Fortune. The table below outlines my detailed earnings model for Apple's fiscal Q4.

Bullish Cross Past Performance

One more thing...Here is how I did against the entire analyst community last quarter. Under one rating done by Philip Elmer-DeWitt at Fortune (click here) I finished 4th overall out of 32 analysts polled. And under Daniel Tello's more comprehensive rating of all the analysts (click here) I finished 6th overall out of 32 analysts polled across all categories. Notice how the bloggers (notated in Green) collectively kicked the ever living crap out of the professional analysts (notated in Red) as a whole. Pay me bitches! I'll come to New York if you give me Kathryn Huberty's job.

How to Protect Apple Profits ahead of Earnings

2010-10-16T12:37:00.000-07:00

A common question on many investors' minds this weekend is how do I protect my Apple profits in 2012 leaps as Apple heads into earnings next Monday. On the one hand, after seeing Google's meteoric 10% surge after earnings, its hard to swallow taking profits especially if Apple ends up gapping up $20-$30 after earnings. Yet, on the other hand, there's the distinct fear that given Apple's huge 28.6% move since early September, great earnings results might already be priced in. (I'll be posting an earnings preview here tomorrow).

There's also the recurring issue of option premiums contracting after earnings even if the stock moves up a few percentage points. It's often the case that while Apple might move up $5-10 points after earnings, the pricing of leaps tends to contract. The reason for this is the reduction in implied volatility. Priced into these premiums is the notion that its possible that Apple can really start to take off after earnings. If that doesn't happen and Apple trades sidewise, the premiums start to come down quite a bit. We saw this happen in July earnings. While Apple popped on earnings, premiums started to contract quite substantially. This despite the fact that Apple's share price actually rose.

There are all types of risks associated with holding any position in the equities market and those risks are even more accentuated when playing with leaps. For Apple in particular, there are a panoply of risks associated with holding leaps. For one, there's always the possibility that Steve Jobs could get hit by a bus. Look at how poorly the stock reacted with only rumors that Tim Cook might be going to HP. Though the rumors were immediately proven false, the stock took a temporary $20 hair cut. And that's Tim Cook. Given that options by their nature have an expiration, and given that the market can remain irrational longer than anyone can remain solvent (Financial Crisis = Apple $78), there's an inherently much higher risk to holding leaps than straight shares which have a better potential for recovery. (Read more by clicking link below)

There's also the risk that Apple may come in line or not beat by quite as large of a margin that many investors have come to expect. Just this past Friday, Senior Analyst Gene Munster at Piper Jaffray argued that Apple would only come in-line this quarter. If that happens, it will have a profoundly negative consequence on Apple's stock price given its nearly 30% move in little under two months time. Right now, Apple is completely priced to perfection.

Essential to doing well as an Apple option investors is first understanding the risks involved in holding leaps, and how to properly manage that risk through some form of hedge or mitigation. Exactly how much risk mitigation is entirely dependent on the level of risk exposure each individual investor would like to assume. There are infinitely many ways one can reduce or increase their level risk exposure.

First, one thing investors often do is just take profits in their contracts. Suppose one owns two January $2012 $300 call options at a cost of $30.00 each. Those contracts have now doubled in value as they closed at around $60.00 this past Friday. By selling one call option ahead of Apple's earnings for $60.00, that investor is now playing with the house's money. If Apple went to $0.00 at expiration, he or she wouldn't lose a penny in the overall principal cost of the investment - at least in theory.

Obviously, things aren't always that simple. The tax consequence could be profound. By selling half the position this year and the other next year, the IRS is going to come after the investor for part of the profits this year even if the overall position might actually break even. He or she could end up losing money on the transaction if he/she pays taxes on the imaginary profits that are lost in 2011. So its not entirely risk-less unless both positions are closed out in the same year.

Secondly, another option investors consider doing is just selling their entire position and trying to get back in at a cheaper price. Yet, by doing this, you run the big risk that the stock just continues to run without a pull-back. By trying to trade in and out of the position, one could get completely priced out of the stock. So that's one risk that should be mitigated if the investor truly wants to participate in the stock. It is key to remember that hedging is a two-way street. One must effectively hedge against both a move up and a move down. But trading in and out of a position could be the level of risk appetite for some are willing and ready to take. It all depends on the individual.

Another hedge lot of very advanced and sophisticated investors consider is a call-spread. Yet, this probably one of the more complex, but efficient ways to hedge a position with several potentially profound consequence. However, it's also really reserved for very sophisticated investors and should only be considered in close contemplation with a professional financial advisor. For those investors who have a very high working knowledge of options and long term leaps, call-spreads are probably the best way to protect profits while being able to continue to participate in a stock's future move.

Suppose John Doe were to purchase two (2) January 2012 $300 Leaps on Apple at a price of $25.00 a contract in early September before this huge move up ahead of October earnings. As of Friday, those Leaps closed at a price of $60.00 a contract. The cost basis was $5,000 total or ($2,500 a contract). Today, they're worth $12,000.00. That's quite a huge gain - nearly 120% in just a little over two months time. Now as we noted above, one thing John could do is just sell half the position and play with $6,000 of the house's money. Not a bad option at all.

Yet, if John wishes to continue his full exposure in Apple, but would like reduce the total risk without selling half his position, he could consider selling one or more calls against his position of the same strike date. For example, he can create something called a "call-spread" by selling the January 2012 $400 call options to substantially reduce the risk to his principle investment.

On Friday, the January 2012 $400 call options on Apple were trading around $22.00 a contract. By selling 2 of these call options (Sell to Open), against his 2 $300 call options, he would bring in $4,400 into his account thereby reducing the total cost basis for the whole position to only $600 ($5,000 original investment - $4,400 for selling the $400 call options). Basically, he's essentially shorting the $400 call options and covering that short position by owning the $300 call options. That way if Apple goes to $75,000,000 a share, he's protected all the way up with the calls he owns.

Remember, his original cost basis was $5,000 (2 contracts at $25.00). Now instead of $5,000 of principal being at risk, only $600 of principal is at risk. This means that if Apple went to $0.00 at expiration, he would only lose $600 as opposed to losing his $5,000 original investment. This is a very good way to protect against Apple missing on earnings, Financial Crisis II, correction off of QE2, Steve Jobs getting hit by a bus, and any number of risks that could conspire to bring Apple down.

It also protects a lot of the profits. If Apple were to fall on earnings, by selling those contracts, it dampens the premium loss as the spread contracts. Instead of losing straight premium, at least by shorting the $400 call options, he's making some of that money back right? For example, if Apple fell $10.00 on earnings, his $300 call options would probably fall $10-$12. But his $400 call options he's shorting would also fall maybe $7.00. That means he would only lose $5.00 of premium instead of losing $12 on the sell-off. He gains $7 for shorting the $400 calls and loses $12 for being long the $300 call options.

So this looks great for protecting a position, but what are the consequences on the total profits? Well by selling two $400 call options, John has given up any and all profits above $400 a share. If Apple went to $1,000 a share by 2012, all his gains would be capped at $400 exactly. John is essentially saying that he doesn't think that Apple will go above $400 on January 2012 and that if it does, he's happy taking all of his profits at $400 a share.

What does this mean exactly for the calculation of the spread? Well it essentially means that John cannot make more than $19,400.00 if Apple closes at or above $400 next year and can't lose more than $600 of his original investment. Max gain = $19,400.00; Max loss = $600.00.

Remember, by selling those two $400 call options, it literally means that John is in for a total $600 investment. Not the $5,000 he originally invested back in early September. The $4,400 actually goes into his account and is free capital that he can use however he wants. This also means that the $600 investment could potentially yield 33 times his investment. That's a 33-bagger!

Mechanically this is how it works. Lets suppose Apple closes at $430 in January 2012. His two (2) $300 call options would be worth exactly $130 a share a piece. The two $400 call options he "shorted" would be worth $30 a piece. So he would be on the hook for $6,000 for the two call options he shorted and would gain $26,000 from the two $300 call options that he was long. He would pay out $6,000 to cover his short position and would get a net payment of $20,000.00 for the two calls that he owned. But he also already had $4,400.00 in his account in cash received when he sold the $400 call options. Now that brings his account total to $24,400.00. If we assume that John originally had $5,000 in his account when he started, that means his account went up to $19,400.00 - this is the total profit.

Just to give an idea of how this impacted his profits, consider the following illustration. If John decided to just go balls-out and unhedged all the way up to $430 in January 2012 with his original $5,000 at risk the whole time, here's what he would have made. His two (2) 2012 $300 call options would be worth $13,000 a piece, which brings his account total to $26,000.00 come January 2012. In this scenario, John lost out on an additional $1,600.00 in profits. At a $450 close on January 2012, he would have lost out on an additional $5,600.00 in gains. At a $500 close, John would have lost out in an additional $15,600.00 in gains. This is one major trade-off for hedging a position with deep gains.

Yet, there are still several other major draw-backs beyond just capping total gains when using a call-spread. Call-spreads offer very little flexibility for exiting with big gains on the run-up to expiration. They really only work best to exit after Apple has either already surpassed $400 a share or near expiration. Which kind of sucks.

For example, lets suppose John does decided to sell the $400 call options at $22.00 a contract on Monday at the opening bell. Now if Apple reports mind-numbing numbers or comes out with some ground-breaking technology three days later and the stock surges to $360 a share, his $300 call options would probably rocket to $100.00 immediately. But the problem is, so would the $400 calls that he shorted. They would probably surge to $35.00. So now if he sold his entire position, he wouldn't have participated in most of the gains had he just held his $300 call options unhedged. If he just held his call options unhedged, they would have gone up to $20,000.00 from $12,000.00. But now, by being hedged, his total position only rose from $12,000 to $13,000.00. Basically, John just lost out on an immediate $7,000 of extra gains.

Essentially loss and profits on a call-spread is determined by the widening and contracting of the price spread between the two call options until expiration. As the stock rises, the spread widens and John makes money. As the stock falls, the price spread contracts and John loses money. So while he loses less if the stock tanks, he makes less on the immediate move up. So basically he has to wait until closer to expiration for the $400 premiums to contract considerably. Which brings us to the next big disadvantage to call-spreads.

Call-spreads do little to protect profits already built-into the original position. While it reduces the risk of the principle $5,000 investment down to only $600 at risk, what about the $7,000 in gains that John already has? While the spread protects those profits in the near term if the stock were to tank off of earnings, that spread will NOT protect John's profits if the stock closes below $300 at expiration. In fact, if the stock closes below $300 at expiration, John would only get the $4,400 that he made by selling the $400 call options. The other $7,600 that John already has is lost.

So what did we learn here? That (a) the spread will protect John's profits in the near term if the stock tanks after earnings as it will dampen some of the losses; (b) it will protect John against a cataclysmic system crash where everything goes to hell in a handbasket - at least he won't lose his $5,000 original investment; and (c) that John's immediate-term gains will be significantly hampered in the near term as he won't be able to participate substantially in any run up into the high $300 range until Apple either substantially breaks $400 well ahead of expiration or unless the stock is near $400 at expiration.

Still, there's no reason John couldn't employ more than just 1 strategy. Given that he has two call options, if he wanted to substantially reduce his risk, he could always sell 1 of the 2 call options and cover the other. For example, on Monday at the opening bell, if John could sell one of his $300 call options at $6,000.00, then he's already in for a $1,000.00 profit. The other $6,000, (house's money) that he has at risk can be covered by selling 1 $400 call option at $22.00 a share.

By doing this, he has now reduced his cost of that $6,000 at risk to only $3,800.00. Now only $3,800 of John's profits are at risk. He has essentially taken $8,200.00 off the table and is playing with $3,800.00 of his profits. In so doing, John has not only moved his principle investment of $5,000 to the sidelines along with $3,200 in profits, but if Apple goes to $400 by expiration, he would gain an additional $6,200 in profits.

Yet another strategy John can employ with a very high risk appetite is to cover just one of his two options. Instead of selling (2) $400 call options at $2,200 a piece, he sells only 1 call option against his two $300 calls that he owns. By doing so, John has reduced his risk exposure to $2,800.00 of his principle investment instead of $5,000. Doing this also allows John to participate in higher short term profits at the risk of losing more on the way down.

What this should outline is that for very advanced investors, there are a several ways to hedge going into a major event like earnings through the use of a call-spread. For the vast majority of independent investors however, it is probably always wise to simply take profits given the complexity and profound consequences that need to be closely monitored when entertaining the use of a call-spread.

One last major advantage to call spreads for those who are especially brilliant at timing the market is using spreads to trade around a core position until expiration. Suppose John set up an account with the intent of employing the entire amount of capital ($5,000) towards an investment in Apple. In this situation, John could sell those two $400 calls for $4,400 on Monday and keep that capital in his account with the intent of employing that capital once Apple sustains a major pull-back. Lets suppose that after earnings, Apple sells-off substantially and the market also undergoes a major correction.

Further suppose that Apple tanks to $265 a share causing the $300 calls to fall back to $25 and the $400 calls tank to $9.00. In this scenario, John can buy 1 more more contract at $25 bringing his total position to 3 contracts and cash position $1,900.00. He can then use $1,800 of that capital to buy back or cover the 2 $400 calls that he shorted. Now John has 3 call options at $25 a piece worth $7,500.00. On the next move up, he can do the same exact thing, but sell 3 contracts to hedge his position instead of 2 contracts. For someone who is really good at timing the market, this is one way to build a major position while always being long the stock. That way if the stock keeps running, he's long and if it pulls-back it gives him an extra buying opportunity.

This is the strategy I'll be employing for a core position in Apple. As of last Thursday, 50% of my call options were covered, and as of the close on Friday I covered 75% of my total long position. I'm holding the January 2012 $350 calls and sold the 2012 $400 calls against my position. I'm very likely going to cover 100% of my position by the closing bell on Monday given Apple's substantial move since September.

Disclosure: At the time of this writing, the author is net long Apple. The information contained in this blog is not to be taken as either an investment or trading recommendation, and serious traders or investors should consult with their own professional financial advisors before acting on any thoughts expressed in this publication.

Apple Surpasses my October $300 Price Target

2010-10-14T08:39:00.000-07:00

In early September when Apple was trading at around $245 a share, I wrote an article explaining that Apple was headed straight to $300 a share by October and that the next move up was for real. That unlike other moves toward $278 that were met with heavy selling pressure, I argued that Apple would surpass $300 before earnings. I also cautioned that Apple would be in for one last pull-back, which we got two weeks ago, and that after this pull-back we would cut straight through $300 with no resistance.

Now that Apple has broken $300 a share ahead of October earnings, I would like to review where things can go from here. First I should say that I'll be updating my Q4 2010 and fiscal 2011 earnings estimates very shortly. But for the intermediate term, here's how I see things potentially playing out. The market has gotten relatively over-extended now and we 'could' see some selling pressure ahead. At least for the short term.

However, what I'll be watching very carefully is how the market reacts to Google's earnings. If Google blows out its numbers and is sold off on its results, then I will be a little more cautious as we head into Apple's results next week. Yet, if Google rises on strong earnings results, then that pretty much should outline what we'll see when Apple reports.

Whenever we have a strong off-season in the market like we've had, the tendency has been to sell earnings in the past. In fact, the last 3 times we saw a 5% rise in the S&P in the off season, we saw a 5% decline during earnings season. This is the result of the market "pricing in" strong earnings results.

That being said, I think Apple is going to uncharacteristically blow out its earnings estimates by a wider margin than it has in the past. In fact, its quite possible that this quarter could be the biggest blowout in the company's history. We'll see how this goes. Given how I see earnings playing out, I'm going to remain long ahead of Apple's results. Even if Google sells-off on its earnings, I'll remain long Apple.

Now as for the intermediate and long term, I firmly stand by my 2012 $400 price target on Apple. In fact, the more I analyze Apple's prospects for 2011, the more I realize just how conservative that $400 price target really is. It is very possible that Apple will reach $400 a lot sooner than people think. My gut instincts tell me that Apple will reach $400 faster than it achieved any 100-point move. One more thing...Don't be surprised if Apple is halted in AH due to unusually strong results this quarter. Good luck!

Disclosure: Long Apple.

Market Report from Cobra's Market View

2010-10-03T00:22:00.001-07:00

I've been following the writings of market technician Peter (Yong) Pan at Cobra's Market View over the past 6 months, and I've got to say that he's probably one of the most valuable sources of market data around the net. He presents his evidence in a rather succinct and objective way, almost always noting both the bull and bear case of the short and intermediate term on the broader market. This weekend's report is of particular importance, and well worth a read for all market participants. You can find Peter's weekend report here.

China PMI and ISM Couldn't get the Market Running...

2010-10-01T08:06:00.001-07:00

Well Friday has come and gone, and strong China PMI and mediocre ISM data couldn't get the market rallying today. So what does the market have to look forward to? We're teetering at the edge of another correction. I bet we sell-off ahead of the employment report next week.

It also doesn't help that the market leaders of this rally are each getting shot in the face one by one. Netflix (NFLX) is down $6.39 today after falling sharply $8 points yesterday. Amazon (AMZN) is down $3.50 or 2.29% and Apple is off $0.60. Tread carefully as we head into next week. 1158 and 1136 are the lines in the sand for the S&P. A break above 1158 or a break below 1136 will determine the market direction for the intermediate term.

Disclosure: Short the QQQQ.

QQQQ Price Action Suggests Correction Incoming

2010-09-30T08:48:00.000-07:00

The QQQQ violated its one-month lower trend line today (Thursday, September 30, 2010 at 8:00 a.m. PST) suggesting that it may be on the verge of another correction. For the past 18-months, a violation of the lower trend line has led to at least a correction in the vast majority of cases and a bigger pull-back in the other cases. Yet, how far this correction can actually go in light of the 10 hefty POMO injections by the fed since August is anyone's guess. What we do know is that the last 3 times the fed initiated 9 POMO injections, the market was up 10% over the next 3-month period.

So while we may be in for a correction, I don't think this correction will be that big. We'll probably bottom out near the 50% retracement of the September rally in equities. Tread carefully right here. Bulls now have to place their hopes on the employment report and the bears need at least one more day of confirmation.

Disclosure: Short the QQQQ.

Apple Getting Over-Extended

2010-09-27T11:07:00.000-07:00

As Apple (AAPL) approaches $300 a share, the stock has gotten overextended in the intermediate term. Yong Pan at Cobra's Market View sent me an interesting chart early Monday morning and has since published it at his site. See here. The bottom line is whenever Apple gets this overextended it tends to lead to an intermediate-term steep sell-off in the stock. It has only gotten this overbought 3 other times in the past 4 years. Most recently at the top of the April 26, 2010 highs.

Its important to note however, that stocks can go overbought and oversold for extended periods of time. Especially a high beta-name like Apple where the stock tends to swing huge in either direction. That being said, I think the pattern in the way the stock tends to trade is pretty important and might indicate some immediate weakness ahead.

I finally exited my $290-$300 October 2010 call spread for a very solid gain. I'm looking to get back into the name once it has had a chance to take a breather. It has already more or less hit my October $300 price target I set when the stock was trading in the $250's a few weeks ago. I think $295 could be the top or very close to the top for at least the intermediate term. The stock needs to pull-back before taking a crack at breaking and holding above $300 a share.

Disclosure: Short the QQQQ as of Friday and Monday.

Apple at Critical Juncture

2010-09-20T08:26:00.000-07:00

Apple is sitting right at $281.00 a share - a critical juncture for the stock. Investors needs to see a swift move above $285 or this action is going to look like a double top. Once the stock breaks $285, I think it paves a clear path to $300. Yet, its going to be hard for the stock to break $300 after the run its had without a good pull-back first.

I still think that October earnings will be the catalyst to drive the stock well above $300 for the first time. Lets see where this momentum takes us over the next few trading sessions.

Disclosure: Long Apple.

Breakout: The Major ETFs are Breaking Out in AH on RIMM Earnings

2010-09-16T13:57:00.000-07:00

Strong results from Research in Motion (RIMM) is sparking a breakout above 4-month resistance on the SPY, QQQQ, and DIA. If this sentiment holds through the night, we could be gapping up over that $113.20 resistance level on the SPY tomorrow morning. Apple also approaching all-time highs in after hours.

Tomorrow we have triple witching Friday option expiration which is traditionally very bullish for the markets. If we close well above resistance tomorrow, I can't imagine who in the hell would hold short positions over the weekend. If we're up big mid-day look for an extraordinary close. Good luck!

The Waiting Game: SPY sitting at Breakout Point

2010-09-16T10:11:00.000-07:00

The SPY has been sitting at breakout point for four days now. Stay put until we get a decisive move one way or the other. We're either breaking out and running to $130 by January or breaking down and potentially testing the lows. So far the SPY hasn't been able to hold above $113 for any sustainable period of time, and the longer we sit up here, the more resistance we get and the more difficult it becomes to breakout.

Going long at $113.50 or higher and shorting on a failure of $111.50. Right here we don't have any guidance as to the direction of the market just yet. I just know the move, whichever direction, is going to be big. So maybe, for those who are interested in getting ahead of the initial move, a strategy buying both calls and puts can work here.

Is the Bearishness in RIMM Overdone?

2010-09-16T08:33:00.000-07:00

According to word on the street, Research in Motion’s (RIMM) best days are behind it. Many contend that the Apple (AAPL) and Google (GOOG) are stealing a critical amount of market share from the company, and that the once dominate BlackBerry maker can barely keep its head over water. CNBC’s Fast Money recently likened the company to the tragic story of Palm, which after suffering from considerable selling pressure was bought out by Hewlett Packard (HPQ) at rock bottom prices. Goldman Sachs (GS) not only dropped it off its conviction buy list, but maintains a sell-rating on the stock.

It seems that every morning some analyst dishes out yet another downgrade. Just Monday Jeff Fidacaro from Susquehanna Financial downgraded his rating to “negative” with a $37.50 price target on the stock. While the market has rallied almost 80% off its bear market lows, the BlackBerry maker is down nearly 70% from its all-time highs. It currently sits just a chip-shot away from its lows set during the financial crisis.

So as the company gets ready to report fiscal second quarter this afternoon, we can’t help but ask: Is all of this bearishness really justified or have recent reports of Rim’s demise been greatly exaggerated?

While no one can speak for the future of the company in any certain terms, one thing is clear. Research in Motion’s financial performance is alive and well. In fact, every quarter that goes by, Rim sets a new record in BlackBerry unit sales and revenue. While Wall Street has now priced in a future collapse in sales, nothing in Rim’s financials suggests such an event will come to pass. The chart below demonstrates just how explosive that revenue growth has been.

Ever since Apple released its revolutionary iPhone in 2007, technology watchers have been touting the death of the BlackBerry. This despite overwhelming evidence suggesting that both Apple and Rim have been able to successfully co-exist within the space. A case can even be made that the iPhone has only helped Rim’s business by pushing smart phones into the mainstream.

In fact, some will be interested to learn that Rim’s best years only began with the release of the iPhone. Nearly five times as many BlackBerry devices are sold today than at a time before the iPhone existed. Even more interesting -- BlackBerry sales continue to outpace that of the iPhone. When the iPhone was first released in June 2007, Research in Motion was selling between 1.8 and 2 million handsets a quarter. Today, Rim sells well over 10 million units a quarter -- a feat Apple has yet to achieve in even its strongest 3-month period.

The two charts below illuminate three key concepts in analyzing the Rim story. First, that despite the widely accepted perception that Research in Motion is struggling to sell handsets, BlackBerry sales are up nearly 43.3% from the same quarter last year -- which were up 44.8% from the previous year.

Secondly, these charts demonstrate Rim’s ability to successfully overcome mounting competition from the likes Nokia (NOK), Google (GOOG) and Apple (AAPL). It also indicates that much of the bearish sentiment in the name is far overdone, and more speculative than based on hard facts.

Thirdly, and most importantly, the smart phone market is clearly large enough to accommodate the success of more than one name. There is this big misconception on Wall Street that only one company can do well in the smartphone space. That it’s a small pie; and that for Apple to do well, Rim has to do poorly. This is an ideological mistake. As anyone can see from these two charts, both Research in Motion and Apple have performed very well over the past three years. Though I’m firmly in the camp that believes Apple will soon surpass Research in Motion in quarterly unit sales, that doesn’t mean that Research in Motion can’t continue to put out explosive growth.

So what if Wall Street is wrong? What if technology analysts are wrong? What if instead of collapsing, Research in Motion continues to perform well within the sector? Is the name undervalued and does it present a good buying opportunity to investors? When compared to other names in the sector, Rim does appear to be severely undervalued.

According to analysts polled by Thomson Reuters, the company is expected to earn roughly $5.55 in EPS on approximately $18.71 billion in revenue during fiscal 2011. This compares to the $4.38 in EPS on $14.95 billion in revenue the company earned last year. That’s about 26.7% in earnings growth and 25.1% in revenue growth.

Moreover, analysts are conservatively modeling for 16% earnings growth over the next 5-years. Yet, the company’s stock only trades at 7.5 times next year’s earnings, has an enterprise value of $21.98 billion, and currently trades at 1x its expected 2012 sales. For a company flush with $2 billion in cash and no debt, this makes Rim at the very least an extraordinary buyout target for a firm like Microsoft (MSFT).

The stock trades at a .51 peg ratio indicating that the stock is undervalued by at least 50%. Rim should probably be trading at closer to $90 a share. This indicates that Wall Street has priced-in a future collapse in BlackBerry sales to the tune of 50% of the stock’s inherent value. If Rim proves that it can continue to compete within the sector, the stock can go on a huge tear. If the market bottoms, employment improves and enterprise spending gets an uptick over the next several years, Rim could be worth upwards of $100 a share.

Yet, on the other hand, any weakness in earnings could send the stock spiraling. A highly volatile and uncertain stock like Rim is not for the faint of heart. If the company begins to underperform, it will only justify Wall Street’s bloated concerns. The company has to execute flawlessly if it has any chance to alter the current ultra-bearish perception on Wall Street.

Disclosure: No Position in RIMM. This article was originally published at Fortune.

Apple: One Last Pull-Back, then Up Up & Away

2010-09-14T15:22:00.000-07:00

The technical picture suggests the market, and Apple is in for one last pull back. After bumping resistance at $113 on the SPY, I think the market will sell-off within the next 1-5 trading days. Don't be fooled by this sell-off though. I think the September momentum in stocks is very similar in nature to the type of momentum we saw in July 2009, and March 2010.

Yet, there still remains some pretty big headwinds as we go into October, and investors should be careful. Moreover, according to Yong Pan at Cobra's Market View, (a trader whom I highly respect) there are some distinct differences in not only the volume, but in the cumulative tick which could suggest that this is a sucker's rally.

Still, whether this happens to be a suckers rally or not, I'm looking to get long Apple very soon. I'm eyeing the 2012 $300 call options. If I could get those things for $25 a contract, I'll be very happy going into next year. Yet, if push comes to shove, I would be willing to buy them at $30. Like I said a few days ago, I think this particular up-leg in Apple is for real. That unlike the other big rallies we've had in the stock since April, this rally is going to hold. The stock might be in for another short-lived pull-back, but after that, we're off to see the Wizard at $300 a share this October.

Disclosure: No Position in Apple just yet. :)

The Monday Trade

2010-09-12T15:08:00.001-07:00

Here's how I plan to trade the QQQQ at the open on Monday. If the market gaps down big at the open, then I'll cover my current short position (holding October $45 QQQQ puts), and go long October calls.

If the market gaps up big on Monday, then I'll double my put position and cover a quarter to half of that position if we close the gap. If the market opens flat to up or flat to down, then I'll increase my put position by 50 to 100%.

I believe the market is in for at least short-term pullback to begin sometime during the trading week. I do actively trade these positions and could easily take a big position at the open Monday and close that position before the close. While I tend to take position at or near the open and close of trading, inter-day trending on the QQQQ tends to determine my exit points.

Gap-Up Big on Monday = Short the Open

Gap-Down Big on Monday = Cover Shorts and Go Long

Flat-to-Up or Flat-to-Down on Monday = Short the Open

Disclosure: At the time of this writing, the author holds October $45 puts on the QQQQ. The information contained in this blog is not to be taken as either a trading or investing recommendation and serious traders or investors should consult with their own financial advisors before acting on any thoughts expressed in this publication.

Apple Bumps Resistance at $265

2010-09-08T10:49:00.000-07:00

$265 forms a major line of resistance for Apple. It has tested and failed that line on five different occasions since April. A break above $265 paves a freeway straight to $280 or higher. This will be a very key price to watch over the next few trading sessions. See here.

In other news, options trading normalized today coming down significantly from the 3-1 put to call ratio seen on the CBOE yesterday. The extreme reading was largely due to two big trades on the SPY $101 and $103 October puts. Yet, obviously yesterday's actions suggests that there is a huge bet being placed on both sides of the trade. That could be viewed as either bullish or bearish.

Disclosure: All Cash.

Surging Put-to-Call Ratio Today (3-to-1) on the Indices

2010-09-07T11:37:00.000-07:00

Something abnormal is going on in equities right now. There's a massive amount of put buying on the CBOE. As of 1 pm EST., there's nearly a 3-1 put to call ratio on the CPCI. This is not even close to normal behavior on the indices. We only see a 3-1 put to call buying on the CPCI in very steep downturns. We could see an immediate huge sell-off coming in equities. It doesn't look good for the short term at least. Last two times we saw put buying of this nature was in September and November 2008. Be careful. Read Cobra's Market View for more this afternoon.

Disclosure: All cash.

Apple headed straight to $300

2010-09-07T08:43:00.000-07:00

After bouncing between $230 and $280 since April, this new move up in Apple is for real. Even as the market pulls back after a healthy move up since last Monday, funds are still rushing in to buy the name. The stock has already moved almost $25 points since its bottom just seven trading sessions ago.

Yet, investors need to be mindful of 1130 on the S&P 500. That continues to be the line in the sand from a technical standpoint. If we break that point on convincing volume, it suggests an intermediate move up to 1250 on the S&P 500. The recent August sell-off was the weakest of the down-legs since the April correction, and this new move up has been the most vigorous of up-legs. This tells us that the overall April to August downtrend is starting to weaken quite substantially.

After the S&P 500 triple bottomed at 1040 last Monday, I changed my stance on the equity market as whole. It's no secret that I've been quite bearish on equities since late April - but based on this recent move up and based on the trading action at 1040 on the S&P, I've become intermediate term bullish on the market. I think pull-backs should be bought and any weakness in Apple is a gift.

Here's how I see things playing out over the intermediate term. The market will probably pull-back a little more from here. While we might move higher in the short term, the market is due for a minor pull-back. Maybe a few hundred dow points. That dip, should be bought. After that pull-back, the market will probably rally to 1130 on the S&P 500. At that point, Apple will probably have rallied to $270 to $280.

From there the market may break 1130 on the S&P 500. If that happens, Apple will see fresh all-time highs well before earnings. And unlike previous earnings reports, September earnings will likely lead to a major move up for Apple. In fact, if the market holds above 1130 when Apple reports, it should be above $300 a share within a day or so after the report. I'm looking for Apple to hit $350 by January.

Disclosure: At the time of this writing, the author is long Apple. The information contained in this blog is not to be taken as either a trading or investing recommendation and serious traders or investors should consult with their own registered financial advisors before acting on any thoughts expressed in this publication.

Bouncing Right off the Lower Trend Line Today

2010-08-25T12:57:00.000-07:00

For the past year, the one thing that has consistently worked in this market is playing the trend lines. The S&P, DJIA and NASDAQ all bounced right off of their lower trend line today. The QQQQ bounced off $44.26, the DIA bounced right off $99.40 and the SPY bounced right off $104.29. I took a long position shortly after the QQQQ rallied to $44.58. I bought 1,000 September $44.00 calls at $0.90 per contract and unloaded that position at an average exit of $1.05 for a nice gain on the day.

Though I continue to hold a bearish intermediate bias on the markets, I think we could be headed higher at least to test the upper trend line of this down trend. The upper trend line on the S&P 500 sits at 1070, $44.50 on the QQQQ and at 10,250 on the DJIA. However, I definitely do not have enough conviction to hold a long position over night. Potentially disappointing jobless claims can easily push the markets right back down to the lower trend line. One thing is for certain, it is almost comical how easy it is to make money off of trend lines right now.

Disclosure: At the time of this writing, the author sits in cash. The information contained in this blog is not to be taken as either a trading or investing recommendation and serious traders or investors should consult with their own registered financial advisors before acting on any thoughts expressed in this publication.

At the Precipice: When Everyone's Fearful...Sell?

2010-08-24T01:24:00.000-07:00

Tuesday, August 24, 2010 - A few days before the July 2010 rally ended, I presented evidence suggesting the broader market was headed for an impending collapse (see here). Since that time there has been rampant discussion of Hindenburg Omens, market dandruff, deflation, double dip recessions and illiquidity in the popular media. The cat is out of the bag. Is it time to go long or will the market unwind despite the general knowledge of very negative indicators?

By now, everyone knows or should know there’s a major 10-month head & shoulders on the S&P 500, Dow and NASDAQ, and that the Hindenburg Omen has been repeatedly confirmed since it first appeared on August 12, 2010. When Maria Bartiromo discusses head & shoulders, and when Jim Cramer talks Hindenburg, that’s when “smart money” knows its time to get out of the short trade. Anytime bearish sentiment becomes popularized, it’s almost certain to be a contrarian indicator.

Don’t believe me - just ask Art Cashin, director of floor operations at UBS. In July 2009, when a head & shoulders pattern on the S&P 500 became popularized and broke to the upside, he told CNBC, “the market will always do what it can to make fools out of as many people as it possibly can.” Translation: fund managers are always looking for pockets of liquidity to either take or unload positions in the equity market, and triggering a short-covering rally is one such pocket of much needed liquidity. Traders were positioned short ahead of a predicted unwind of the June 2009 head & shoulders, and when the market gapped up the Monday following a breach of the neck-line, a massive short covering rally ensued over the next 3-week period.

So the question that should be on everyone’s mind is given the fact that everyone is aware of this 10-month head & shoulders, the Hindenburg Omen and September crash thesis, does it now necessarily mean a collapse is no longer in the cards?

I’ve been generally bearish on the equity market since April (see here), and have made a killing on both short and long trades over the past several months. Yet, the one thing that keeps me up at night is the fact that too many people could be positioning short ahead of a potential September sell-off. That it’s becoming a crowded trade, so to speak.

This is or should be the largest concern for the short view right now. However, that being said, I think it’s becoming exceedingly likely that despite the fact that much of the market is generally aware of these obvious warning signs, it will do very little to stave off a significant sell-off that will probably bring the Dow to 8,800 or lower. In the vast majority of cases, I would agree with the convention that rising expectations of a sell-off lowers the general probability of that sell-off actually occurring. However, in this particular case I think we’re headed lower despite this long-standing principle.

First, institutional buying has fallen off a cliff over the past several weeks indicating a lack of accumulation that generally precedes a big move up in the markets. Instead of buying on weakness, institutional investors have moved to the sidelines since the end of July. In fact, institutional buying has dropped to the lowest level in more than year and has been steadily declining since June. This significant lack of accumulation can only be interpreted as a shift to a far more defensive stance by big money. If the market is really set to rally against this head & shoulders formation on the S&P 500 as some might suggest, we would see a lot more conviction from institutional investors. Read more at Cobra’s Market View.

Secondly, it’s not as if everyone is just piling into puts going into September. According to the $CPC, an index that tracks the daily put-to-call ratio on the Chicago Board of Options Exchange, far more traders are currently positioned long than short. Most of the time, when we get a low reading on the $CPC it’s a leading indicator and suggests the market is likely headed higher in the short term. In fact, based on a back-test performed at Cobra’s Market View, in 41 out of the last 59 cases (70%) where the $CPC closed below 0.81, the market closed in the green in the following trading session.

Yet, there are times when the $CPC can be a contrarian indicator. If everyone and their mother piles into short or long positions, it could implicate a change in trend. In fact, that’s exactly what we saw in April when the $CPC closed well below 0.60 suggesting that the market participants were simply getting too bullish. A reading of 0.50 suggests a 3-1 call-to-put ratio.

Just a week after that extreme April reading, the market commenced the biggest correction in over a year. We also saw the same happen in the opposite direction when traders got overly bearish in late June as indicated by a close above 1.50 on the $CPC (3-1 put-to-call ratio). Though investors saw a few days of continued selling pressure after the extreme reading, the market quickly reversed course and saw a massive rally in July.

Based on Monday’s relatively extreme close of 0.71, way more people are betting the market is headed much higher rather than lower at least in the short term. This indicates that though market participants might be aware of the Hindenburg Omen, the head & shoulders on the S&P 500 and the general crash thesis, they’re certainly not positioned that way.

So while retailers continue to buy large amount of calls on equities as we head into September, institutional investors have been moving to the sidelines. Usually, we only see this type of activity at market tops, not bottoms. Though the market has been in sell-mode for the past several weeks, trader sentiment has been generally bullish based on option activity.

Yet, putting all of this nonsense aside, here’s the bottom line. Everyone who is anyone has their eye on 1010 and 1130 on the S&P 500. If we break below 1010, we’re headed much lower. At least to 950, which happens to be the 50% retracement of the March 2009 to April 2010 rally. Whether the market goes any lower than 950 will largely depend on market sentiment come September/October.

If, on the other hand, we break above 1130 on the S&P, then we’re likely headed to 1300 or higher by year’s end. There is at least some evidence suggesting this is somewhat possible. There’s a clear 6-week inverse head and shoulders on the S&P 500 with the neckline sitting at 1130. Inverted head & shoulder patterns are very strong bottoming formations and should be taken seriously. In fact, the 2007-2009 bear market bottomed out with an inverted head & shoulders pattern.

Those are the two lines in the sand, and everyone knows it. What’s left to be determined is the potential catalyst that can drive the market beyond 1130 or below 1010. Right now, the evidence clearly indicates the market is far more likely to break down than rally out. For one, the economic data has all been very negative over the past several weeks. The market absolutely hates uncertainty, and the economic outlook is very uncertain at the current moment. Any piece of economic data can spark a major sell-off. Weak employment data for August can send this market spiraling. Last week’s Philly Fed index was just but one example of how the market can be unpleasantly surprised by weak economic data.

Market Opportunities
A sell-off to 950 on the S&P 500 will likely present some good long-term opportunities. Starting with my all-time favorite, Apple (AAPL) has been and continues to be the super star of the NASDAQ-100 (QQQQ), and the long-term outlook for the stock looks very bright. Yet, in the short term, the stock could easily see the low $200’s before this correction is over. At that price level, I’ll likely be considering a long position in some 2012 leaps. Apple closed at its 5-month support of $245 on Monday. Despite Apple’s strong fundamentals, it has a long history of following the general direction of the broader market. Heavy selling in the cubes (QQQQ) continues to put a lot of pressure on the stock.

Bond yields will probably continue to contract as we head into September and October making the 20+ Year Treasury Bond Fund (TLT) a good candidate for a short position as it climbs to ungodly levels not seen since December 2008. At the 50% retracement, the broader market ETFs (SPY) or (DIA) could be an attractive long-term play. Google (GOOG) could see the low $400’s on a final leg down in the markets likely making it attractive to institutional investors looking for value.

Intel (INTC) continues to post very strong earnings, and is once again, like Apple, the innocent bystander in this sell-off. Though the name sits at the lows for the year, it does have a gap to fill in the low $16 to $17 range. If Intel happens to see that level, it is sure to attract a ton of institutional interest as a steal on value. Goldman Sachs (GS) is another name I’m looking at very closely. If it can hold support at $130, it’s likely to be very attractive to long-term investors. Personally, if I do ever invest in individual names, it’s always best in breed – a benefit of not having a massive liquidity problem.

Disclosure: At the time of this writing, the author holds not position in the equity markets. Though that is likely to change at any moment. The information contained in this writing is not to be taken as an investment or trading recommendation and serious traders or investors should consult with their own registered financial advisors before acting on any thoughts expressed in this publication.

The Case for a $50 Billion Facebook

2010-08-23T01:25:00.000-07:00

Like many privately held companies, Facebook has always been very tight-lipped about its financial performance only telling us that it went cash flow positive for the first time in September 2009, and that it’s user-base recently eclipsed 500 million subscribers. Yet, this doesn’t stop scores of Silicon Valley analysts from speculating on the company’s finances by evaluating the various trends in advertising revenue and user growth. Nor does it stop big investors from taking sizable stakes in the company in the hopes of getting handsome returns on a future IPO that some suspect could happen as early as 2012.

Based on a recent study released by eMarketer, Facebook is expected to bring in roughly $1.3 billion in revenue in 2010 nearly doubling the $665 million the research firm estimates it recorded in 2009. Yet, despite Facebook’s enormous revenue growth, it currently only brings in a meager $0.56 per 1,000 page impressions compared to the industry average of $2.43. Furthermore, according to current estimates provided by Second Shares, Facebook makes only about $2.60 per user on an annual basis, which is significantly lower than the $18 made by Google (GOOG) or the $12 made by AOL (AOL).

So while Facebook is poised to surpass Google with its 500 million users making it the most popular website on the net, some are concerned with Facebook’s ability to fully monetize its user-base, and question whether privately traded shares of the company might be overvalued. Facebook has yet to capitalize on its subscribers in a meaningful way and has made very little progress on the revenue per-user front.

Yet, it's also important to remember that other Internet-based companies started in a similar way -- including Google -- and that Facebook could easily improve upon its anemic revenue per-user growth.

While the company has no immediate plans to make a public offering, shares of Facebook already trade on two private exchanges attracting investors of the likes of Microsoft (MSFT), Digital Sky Technologies and Chinese Billionaires. So what is Facebook really worth, and what might it be valued on IPO?

According to Next Up Research, private investors were valuing Facebook between $11.1 and $12.5 billion earlier this year. Today, they're valued at $24.9 billion, according to a similar analysis offered by Bloomberg.

And, according to Larry Albukerk, a specialist at EB Exchange Funds who privately brokers shares of Facebook, the company occasionally trades at an even higher valuation. “There are very large, sophisticated institutional investors who are buying at a $30 billion valuation,” he recently told MSN Money.

Those are some big swings. Yet, Facebook investors are all too familiar with the huge volatility. When Microsoft (MSFT) took a $240 million sake in the company in October 2007, the purchase was based off a $15 billion valuation—the same valuation it had in early 2008 when Hong Kong billionaire Li Ka-Shing took the second of two $60 million stakes. But by 2009, Facebook’s value had dropped. A $200 million stake taken by the Russian technology firm Digital Sky Technologies in May 2009 put the company at a valuation of roughly $10 billion. That’s a $5 billion drop from the previous year’s valuation.

So are private investors getting overzealous in their assessment of the company or will these large stakes prove as lucrative as those who had the vision to get ahead of Google’s IPO? The answer to that question largely depends on Facebook’s ability to monetize its user base. 500 million subscribers is a staggering number for any company especially when considering that Facebook already owns nearly half the world’s Internet users. Yet, as the financial community learned with YouTube, having a gaggle of users is only one part of the equation. The ability to make money on those users is key to determining value.

When discussing this issue with senior analyst Debra Aho Williamson at eMarketer, I got the sense that Facebook will probably be able to monetize its user-base more efficiently in the coming years as a result of an impending shift in Facebook’s business strategy. That though half of Facebook’s current growth comes from the blockbuster success of its self-serve ad platform, its future lies with big-brand advertisers who are starting to show tremendous interest in being able to reach customers through the Facebook business model.

Procter & Gamble (PG), the world’s largest advertiser, continues to take a significant interest in Facebook, suggesting that other big brand names might soon follow. While Facebook’s self-serve ad platform has been responsible for much of its recent success, this pales in comparison to the type of revenue explosion Facebook will see from increased CPM rates offered by big brands.

Secondly, according to Williamson, Facebook will soon see a significant uptick in user-growth through international markets, which is very key in making the overall platform attractive to brand advertising. As Facebook reaches more users world-wide, internationally recognized brand names are inclined to become far more interested in reaching its customers through this near universal platform.

Despite the company’s massive install base, it’s still far outpacing Google’s growth in users. According to recent estimates, Facebook grew its user-base by 150% in 2009 versus Google’s 40% growth based on similar metrics. So even if the company doesn’t make immediate inroads in its CPM (cost per thousand page impressions) and CPC (cost per click) rates, user growth by itself is propelling much of the company’s 100% revenue growth.

And even if Facebook doesn’t substantially raise its revenue per user in the immediate future, the company’s staggering user growth by itself justifies a valuation of nearly $50 billion over the next several years. Facebook is expected to earn nearly $1.8 billion in revenue in 2011 and that’s based on a projected 600 to 700 million users. Google currently trades at a $150 billion market capitalization and the only thing standing between Google and Facebook is Google’s revenue per user. If Facebook were to produce similar revenue per user rates as Google, the company could potentially be worth upwards of $150 billion.

Finally, it is this potential to capitalize on such a huge user-base that will likely drive a lot of speculative demand for the company on IPO. Traders are already bidding the company up to $30 billion. In fact, when asking Paul Bard, director of research at Renaissance Capital, about the potential for a successful Facebook IPO, he noted, “Facebook could do an IPO tomorrow and the offering would be met with huge investor demand.” Renaissance Capital is the global leader in providing independent and investment management services on IPOs. Paul Bard, on his part, believes the company to be conservatively worth about $20 billion today.

Based on my conversations with some of the leading analysts in the industry, I think what investors will likely see on Facebook’s IPO is a rally not seen since Google’s public offering. Many investors missed out in getting ahead of Google’s meteoric stock surge, and Facebook will give investors a second opportunity to participate in a blockbuster IPO. Facebook is probably already worth $50 billion, and will likely march toward the $150 billion valuation over the next several years. This article was originally published in an edited-down version at Fortune.

Disclosure: At the time of this writing, the author holds no position in the equity markets. The information contained in this blog is not to be taken as either an investment or trading recommendation and serious traders or investors should consult with their own professional financial advisors before acting on any thoughts expressed in this publication.

Apple $400: A look at Apple's Fundamentals Part II

2010-08-12T22:52:00.000-07:00

In Part I of this series, I discuss the general risks of using valuation as basis for placing short or intermediate price targets on Apple (AAPL), and how having a long-term viewpoint is the only appropriate way to rely on fundamentals for investment decisions. That the day-to-day fluctuations in Apple’s stock price are more determined by the larger concerns of the broader market than they are with the company’s strong fundamentals.

So keeping these concerns in mind, what investors want to know is: what is Apple worth and is the company currently undervalued? The short answer - Apple is definitely undervalued, and it should be trading at around $400 come 2012.

Traditional Valuation Metrics: Trailing & Forward P/E Ratios
The very first thing investors learn about fundamental analysis is that stocks are generally valued on a price-to-earnings ratio, and that a stock’s growth rate is what determines the multiple it receives in the analysis. For example, on a traditional trailing 12-month P/E valuation analysis where one multiplies Apple’s $15 in EPS by its 70% growth rate, Apple ‘should be’ worth about $1,050 a share on a trailing basis come this October.

Yet, as anyone who takes valuation seriously knows, stocks are seldom valued on their trailing P/E ratio. Instead, the market tends to value stocks based on their future expected earnings and long-term expected growth rate. In other words, key to the equation is what will Apple earn over the next 12-months, and what is expected out of the company in terms of growth over the next 5 years. Cash also plays a very important role in the analysis, but not in the way one would expect. We’ll get to cash in a moment.

So setting aside the issue of Apple’s enormous cash position, Wall Street analysts are generally modeling for Apple to earn $14.43 in EPS for fiscal 2010 and approximately $17.47 for fiscal 2011 – that’s about 21% earnings growth. Moreover, when looking at what is expected out of the company over the next 5-years, analysts are modeling for about 18% earnings growth. Thus, based on these conservative variables, Apple should be currently trading at about 18 times next year’s earnings of $17.47 in EPS or about $314.46 a share. That’s about $54.46 above Friday’s close.

Looking at the future trailing P/E to beat Wall Street
Yet, simply analyzing Apple’s (AAPL) forward P/E ratio doesn’t really tell anyone what the company ought to be worth in the future. It only tells us whether the stock is currently undervalued, and what it ought to be trading at today. To get an idea of what the company will be trading at in the future, it is vital to ascertain not only what type of trailing P/E the market is likely to give Apple in late 2011 or early 2012, but what the company will actually report in earnings. This is precisely where investors can beat Wall Street at their own game, and sums up the value offered by independent analysts who consistently outperform Wall Street in forecasting Apple’s earnings.

If there is one thing that readers should take away from this article it’s that you should never fight Wall Street’s valuation metrics. Instead of relying on some alternative way to valuate the company to determine future price targets, embrace the market’s valuation but beat it on the earnings front. For while the market might continue to give Apple an 18 to 20 trailing p/e ratio well into the future despite Apple’s enormous cash holdings and robust 50-70% growth rate, the one thing that is not determined by the market is the earnings variable of the P/E ratio.

For example, let’s suppose that Apple continues to trade at a 19 to 20 trailing P/E come October 2011. Right now Wall Street analysts are modeling for Apple to earn roughly $17.50 in EPS. At that earnings level, Apple would be trading between $332 and $350 assuming a 19 or 20 multiple. Yet, nearly every independent analyst knows Apple will probably earn about $20 in EPS in 2011.

This is where investors can beat the street in forecasting a more realistic and achievable price target. Based on $20 in EPS for fiscal 2011, Apple should be trading between $380 and $400 in late 2011 early 2012 assuming a 20 multiple. This price-target beats the street by nearly $70 in share value, is based exclusively on the market’s current valuation of the stock, and presents a conservative, simple, and straight-forward analysis of Apple’s valuation.

Basing Price Targets on Wall Street Valuation Metrics not on P/E(x-cash)
Yet, if I ended the analysis right here, I would get no less than 40 messages in my inbox by disgruntled investors explaining to me that it’s irresponsible to valuate Apple on a retroactive trailing P/E basis without backing out Apple’s cash from the analysis.

For example, my 2011 model calls for Apple to generate roughly $18 billion in cash in addition to the $45.8 billion already stockpiled in the company’s coffers. That is a total $63.8 billion or 39.3% growth in cash over the coming year. If one were to back out this cash from Apple’s expected (2011) market capitalization of $376.4 billion, Apple would be trading at a trailing P/E(x-cash) of only 16.6.

Some would even go so far as to argue that Apple should be assigned a 25 P/E(x-cash) in order to conform with a more realistic 5-year growth rate; and that based on an expected $20 in earnings, it should thus be trading at $600 a share on a 30 multiple.

Yet, it’s very unrealistic to assume that the market will suddenly wise up to Apple’s (AAPL) enormous cash position and higher growth rate, and give it a 30 trailing p/e when Wall Street expects Apple to report a mere 18% earnings growth over the next 5 years. For while some might argue that its unreasonable to suggest that Apple will grow at such a meager pace, the market is not so easily convinced. Even if Apple demonstrates that it will far exceed the 18% growth expected over the next 5-years, it will do very little to alter the market’s foregone conclusion to the contrary.

There seems to be this underlying notion with investors that there will be some glorious day deep in the future when Wall Street eventually gives Apple a valuation that is perfect in every regard, and which contemplates the full potential and thrust of Apple’s business model. Theoretically, Apple should have traded at a 50 P/E over the past 5 years, but has only seen that valuation level for only a few moments.

Research in Motion (RIMM) is a fundamental powerhouse growing at astonishing rates, but the market continues to hold the belief that iPhone and Android are going to destroy the Blackberry despite repetitive evidence to the contrary. Research in motion has repeatedly demonstrated its ability to keep up with the competition in the smart phone industry, but the market refuses to give the stock a P/E ratio higher than 10. Altering the market’s perception is no easy task.

Furthermore, the historical record indicates that Apple will likely see an 18 to 22 P/E well into the future. Horace Dediu, a rising star among the independent analyst community, recently published a chart comparing Apple’s stock price, trailing P/E ratio and trailing P/E ratio (x-cash), which I find to be essential in determining the long-term direction and valuation of stock.

From a brief analysis of this chart, one should notice that while Apple has fully recovered and even made fresh all-times highs from the lows of the financial crisis, its P/E ratio has barely even moved. In fact, it has remained relatively flat over the past year and a half indicating apprehension on the part of Wall Street to give Apple a multiple significantly greater than that enjoyed by other similarly situated mega-cap stocks.

The Market Capitalization & Return on Equity Problem
Instead of giving Apple the fairest possible valuation to determine the stock price, market participants are relying on Apple’s earnings to drive the stock higher. It is clear that the earnings part of Apple’s P/E ratio has been the determinative factor in the rise of Apple’s stock price over the past 18 months and not a fair valuation. While Apple will probably continue to grow in the 25% to 30% range over the next 5 years, the market is unlikely to give it a P/E any higher than 23 at the high end or 15 at the low end for any extended period of time.

Eventually, all large-cap stocks undergo an age of P/E compression in anticipation of the law of large numbers and lower long-term anticipated growth rates. Even large cap tech companies that continue to significantly outpace the growth of their valuation nevertheless experience major P/E compression. This acts as a ceiling to overall market capitalization and mitigates the problem of return on equity.

When discussing this issue with analysts, I hear the same repetitive concern about Apple’s market capitalization. That despite Apple’s growth rate, business potential, and staggering piles of cash, the fact that its market capitalization is about to surpass Exxon Mobil (XOM) to make Apple the largest company in the United States raises questions about its expected return on equity (eROE). And this is precisely where the issue of cash, expected cash flow and trailing P/E(x-cash) becomes front and center in the equation.

Whenever one debates whether Apple (AAPL) should have a larger market capitalization than Exxon Mobil (XOM), Wal-Mart (WMT), Microsoft (MSFT), Hewlett Packard (HPQ), Google (GOOG), or IBM (IBM), the central issue in the discussion is which of these companies have the highest expected return on equity. That is, for every dollar spent to purchase one of these institutions, which of them would yield the highest return per dollar spent? If someone were to purchase Apple at $375 billion outright, would he or she get a bigger return on that $375 billion or would he or she get a greater return by spending $315 billion to acquire Exxon Mobil? If one produces a higher return with Apple, then Apple is relatively more undervalued than Exxon and vice-versa.

This is precisely why there’s an artificial ceiling on market capitalization. For if Apple were to reach levels clearly suggesting a higher return on equity for Exxon Mobil (XOM) or any other similarly situated mega-cap name, it literally means that Apple is over valued relative to that name. At $400 a share, Apple would have a market capitalization of $376.4 compared to Exxon Mobil’s $315 billion cap, Wal-Mart’s $192.1 billion or Microsoft’s $221 billion market cap.

Yet, having a higher market cap in and of itself isn’t a problem so long as the analysis demonstrates that Apple will likely post a higher return on equity on its market capitalization. Moreover, cash and cash flow must be subtracted from market cap because hypothetical purchasers of the company would get that cash in the acquisition. Thus, net market capitalization becomes the basis for comparison.

This is exactly what investors who think Apple should have a 30 P/E on an expected $20 in earnings fail to realize. At $600 a share, Apple would have a market capitalization of $565 billion or more than Microsoft and Exxon Mobil put together. It is outrageously doubtful to suggest that Apple will somehow demonstrate a higher return on equity than Microsoft (MSFT) and Exxon Mobil (XOM) put together.

I hope this demonstrates why it’s almost silly to believe that the market will give Apple a P/E ratio much higher than what it currently trades at in late 2011. Instead, Apple’s future stock price will largely be determined by its growth in earnings as it continues to undergo further P/E compression well into the future. I’ll be exploring the issue of comparative return on equity and comparative market capitalization in future articles to ascertain Apple’s true value. Stay tuned.

Disclosure: At the time of this writing, the author held September $46.00 puts on the QQQQ but has since sold those puts on Thursday afternoon and is now 100% in cash. The information contained in this blog is not to be taken as an investment or trading recommendation and serious traders or investors should consult with their own professional financial advisors before acting on any thoughts expressed in this publication.

Apple $400: A look at Apple's Fundamentals Part I

2010-08-11T16:24:00.001-07:00

Until recently, I’ve been silent on the issue of Apple’s (AAPL) valuation because I feel that such an analysis could be misleading when improperly used to try and forecast Apple’s short or intermediate term price action. Far too many people are betting that Apple will see $300 or $400 a share by this January owing to its strong fundamentals. While I agree that Apple is worth a lot more than what is reflected in its current market price, a long-term viewpoint is the only practical way to rely on fundamental analysis as a basis for investment decisions. Allow me to illustrate.

On August 20, 2008, renowned Apple analyst Gene Munster argued on CNBC’s Fast Money that technology stocks generally tend to outperform in the fall and winter months, and that Apple’s cheap valuation meant that it was time to buy the stock. Munster had a famous $250 price target on Apple at the time. In fact, nearly every analyst on the street had $200 price targets on Apple citing exceptionally strong “fundamentals” as a basis for their recommendations.

Yet, 30 trading sessions later, Apple (AAPL) dropped from $175.84, when Munster and several hundred other market participants were touting the stock as being “undervalued,” to a close of $89.16 on October 7. Apple wouldn’t see $200 a share for almost 15 months. Nearly every analyst on the street flipped 180 degrees on Apple cutting price targets, estimates and citing valuation concerns as a basis for downgrading their buy recommendations to neutral and sell.

RBC analyst Mike Abramsky cut his price target from $200 that August to $125 in late September. Morgan Stanley’s Kathryn Huberty cut her price target on Apple two weeks in a row from $190 to $179 on September 22, 2008 and again from $179 to $115 a share just one week later. By mid-November, Apple stabilized in the $80 to $90 a share range. Even long time Apple enthusiast Jim Cramer noted on several occasions during this period that he couldn’t recommend Apple at $90 a share.

Meanwhile, Apple reported one record quarter after another, and it even posted 125% earnings growth in the September quarter of the financial crisis. The iPhone deferred revenue system masked Apple’s true earnings power making it very difficult for fund managers to adequately valuate the company during the post-crisis P/E compression era. And though the company was undervalued, it didn’t stop the market from pricing the stock at a 70% discount to its theoretical value.

By the end of October, I published a detailed analysis demonstrating that Apple was likely the most undervalued large cap tech stock in the sector. I argued against long time Apple enthusiasts that despite what the investment community might hear from analysts, Apple was a strong buy at $80 a share. I made several arguments as to why the market would bottom in March and that Apple would see $230 within a 2-year period.

Yet, instead of seeing opportunity in Apple’s (AAPL) cheap valuation, Mike Abramsky downgraded the stock to underperform in January 2009, and lowered his price target to $70 a share. The market bottomed just a month and a half later, and Apple significantly outperformed the market posting nearly 250% gains in the next year and a half – more evidence that fundamental analysis is only valuable when used to make long-term predictions. So what exactly did Mike Abramsky’s clients gain from this analysis? Abramsky, like nearly every other analyst, was literally advising clients to buy in the $180 a share range and sell at $80’s a share. Is it any wonder why analysts continue to be the laughing stock of Wall Street?

The lesson here is not that so many got it wrong ahead of and during the financial crisis, however. Rather, what investors should take from this history lesson is that price targets are often good in theory but fatal in fact. Attempting to put intermediate or short-term price targets on any stock based exclusively on fundamental analysis is really an exercise in futility. And before you dismiss the financial crisis as merely an outlier, think again. Apple’s stock has collapsed by over 30% on at least 4 separate occasions over the past few years. See here.

Secondly, and more importantly, it’s very hazardous to rely on a stock’s fundamentals to put a floor underneath its price. All stocks are risky assets, and have the potential to trade at very distressed levels. To unequivocally deny the possibility that Apple could see a short or intermediate term collapse just because it has strong fundamentals is one of the most dangerous viewpoints that anyone could entertain. While its very unlikely that Apple will see such distressed levels anytime soon, the point here is that strong fundamentals don’t make certain stock immune from torture.

Quite often, investors are forced to unload their biggest winners in order to meet hedge fund redemption requests. Other times funds de-risk by shifting-away from an equity strategy to the safe haven of less riskier assets in fixed income. Macro-economic concerns can lead to massive short-term declines in share value. There are countless factors that can conspire to bring Apple down to extreme levels. In fact, colossal mutual funds outflows have been ongoing for the past several months indicating that a major sell-off might loom on the horizon. With a major lack of market participants, any major event can completely unhinge this market.

Research in motion (RIMM) is a fundamentally sound institution that is clearly undervalued on any widely accepted metric of valuation. That doesn’t stop the inefficient market from pricing the stock at less than half of what ought to be worth. Every stock, including Apple, is at the whim of the larger concerns of the broader market.

So just because a stock has strong fundamentals, just because it is undervalued based on widely accepted metrics, or just because everyone has $300 to $400 price targets doesn’t mean that the stock will see those levels in any short or intermediate term time frame. Instead, the only advantage available to investors is having a long-term viewpoint of the markets. Apple is probably worth $400 a share – but only in the long term. The only thing one can say with any degree of confidence is that Apple will probably see much higher levels some time within the next few years.

Keeping these reservations in mind, I’ll be offering a thorough fundamental analysis of the company. But I would be remiss if I didn’t first disclose just how cautious investors should be when entertaining these very theoretical exercises. Price targets are really just a picture of what a company ought to be trading at in a theoretically rational, and efficient market sometime in the distant future. And yet, this market is rarely rational and hardly efficient in its pricing structure. Please don’t take my skepticism of using fundamentals to forecast short-term price action as general skepticism toward Apple. That would be a gross misinterpretation of this analysis. Instead, view this analysis as a sigh of caution regarding fundamental analysis in general. Stay tuned. This article was first published at Fortune.

Disclosure: At the time of this writing, the author holds September $46.00 puts on the QQQQ. The information contained in this blog is not to be taken as either an investment or trading recommendation and serious traders or investors should consult with their own professional financial advisor before acting on any thoughts expressed in this publication.

A Short Comment on Using Fundamental Analysis

2010-08-09T10:39:00.000-07:00

The editors at Fortune published a story I wrote for them today on a certain level of caution that investors should use when relying on fundamental analysis as a tool to make short or intermediate term price projections for Apple (AAPL) or any other company. Though valuation proves very useful for making long-term predictions, history has taught us that patience is key when making investment decisions.

Even today, Apple has been very range bound largely due to the sizable market correction that began on April 26 suggesting that Apple, like nearly every other company, is at the whim of the larger concerns of the broader market at least in the short-term. As I noted in the article, I'll be running a second piece on Apple's long-term valuation this week, but I had to stress just how important it is to have a long-term horizon on the company when relying on valuation as a basis for investment decision. So much so that it warranted a full article on the subject. You can read the full piece here.

An In-Depth Look at Apple's September Quarter

2010-08-03T15:23:00.000-07:00

As the market continues to fully digest Apple’s recently reported fiscal Q3 earnings, I would like to take a look at what’s in store for the September quarter. Since there’s very little concrete data in the form of research reports, channel checks, and order tracking being that it’s so early on in the quarter, I’ve analyzed Apple’s (AAPL) guidance and the general seasonal and yearly growth trends to form a pretty reliable picture of what investors should expect to see when Apple releases results this October.

The biggest highlight in Apple’s fiscal Q3 earnings report was its uncharacteristically aggressive revenue guidance. The street was generally looking for Apple to provide guidance in the range of $16 to $16.5 billion, and Apple far exceeded those estimates with their incredible $18 billion estimate. Everyone knows Apple’s management to be overly conservatively when providing forward looking statements. So to see an $18 billion estimate come out of Apple was clearly the biggest surprise I’ve witnessed in a long time.

Yet, as many Wall Street analysts have noted in their estimates, there’s reason to breathe caution into the air when relying on Apple’s guidance this quarter. I believe Apple’s management has become slightly more aggressive with its estimates simply because I don’t see where Apple will be able to derive the revenue to far exceed its own expectations this time around. The street is generally modeling for Apple report $3.95 in EPS on $18.29 billion in revenue. While I think the street is a tad bit low in its forecast, I don’t believe Apple will beat estimates by quite as wide of margin as it has in recent quarters. I’m currently modeling for Apple to report $4.45 in EPS on $19.1 billion in revenue.

Philip-Elmer DeWitt at Fortune puts forth a very interesting theory as to what might explain Apple’s seemingly aggressive $18 billion guidance this quarter. He notes, “Wall Street is either betting that apple was hyping its revenue forecast, perhaps to send a message about the death grip flap. Or the analysts, in a time-honored sell-side ploy, were doing some low-balling of their own so clients who follow their advice and buy Apple shares might be pleasantly surprised come the end of the quarter.”

Both of these theories are quite plausible though I think I buy into the former explanation that Apple was trying to send a message about the negligible financial impact of “antennagate.” Based on Apple’s guidance in conjunction with the seasonal and yearly growth trends, the tables below outline my forecast for Apple’s fiscal Q4. Please be advised that actual results may vary. You can review my track-record on Apple published at Fortune. Philip-Elmer DeWitt keeps an ongoing score of analyst accuracy in his column, Apple 2.0. See here. (click to enlarge)

For those who care to swim in the minutia, the detailed analysis below forms the basis of my initial estimates. Starting with unit sales and revenue, whenever one draws estimates it’s important to keep Apple’s guidance squarely in mind. If the seasonal and yearly growth trends suggest a revenue number that is far below or beyond the range that Apple tends to beat on its own guidance, then either the estimates aren’t fairly stated or there’s something uncharacteristic about Apple’s guidance.

Most of the time, estimates that fall outside of the normal variance will likely be the result of an error in the methodology rather than a change in Apple’s guidance behavior. Though as I noted above, I think that for this particular quarter, Apple is in fact guiding slightly more aggressive than usual. This much is clear. I’ve drawn up some rather aggressive estimates for Q4 that I think will be pretty difficult for Apple to achieve. And even if Apple meets or slightly exceeds my expectations, it will be a much lower beat than what we’ve seen in the past few quarters. Note: If you don’t want to get too bogged down with detail, stop reading here.

I. UNIT SALES & REVENUE
In the sections below, I lay out the details of my revenue model for Apple’s September quarter. The issue of Apple’s income statement will be taken up in section II of this report.

iPhone Unit Sales & Revenue
It has been somewhat difficult to gauge demand for the iPhone 4 beyond what Apple seems to be telling us with its guidance. Since Apple, as recently as mid-July, has been suffering from iPhone 4 supply constraints, we have very little data in terms of the full potential run-rate for the iPhone. That being said, what we can analyze is the current seasonal and sequential growth trend, and come to a number that is commensurate with Apple’s aggressive revenue guidance.

In fact, knowing that it’s much easier to predict Apple’s other product categories, I’ve determined that Apple must sell about 11.5 million iPhones this quarter to meet the implications of its revenue guidance. Analyst estimates seem to range between 10 and 12 million units, but 11.5 seems to be more consistent with Apple’s guidance. Moreover, an 11.5 million iPhone estimate is more or less in harmony with the seasonal, yearly, and sequential growth trends as well.

Starting with the sequential growth trend, last year Apple saw a 41% quarter over quarter increase in iPhone unit sales between fiscal Q3 and Q4. The September quarter tends to see a significant uptick in unit sales due to Apple’s practice of releasing new iterations of the device at the end of June quarter. Based on last year’s sequential growth trend, Apple could sell about 11.8 million iPhones compared to the 8.4 million it sold in Q3.

The current yearly growth trend also seems to support this thesis. For the past few quarters, Apple has enjoyed some rather staggering iPhone growth rates. For Q1, Apple recorded 100.2% unit growth, for Q2 it recorded 131% and for the recently reported Q3, Apple saw 61.3% year over year growth. Thus, an estimate calling for 11.5 million iPhones would suggest a 56% yearly growth rate, which is more or less consistent with the growth rate seen in Apple’s previous three quarters.

The average selling price of the iPhone and its related products and services is much easier to gauge. The trend has been more or less consistent across the previous four quarters. Apple has generally reported an iPhone ASP range of $620 to $635 over the last several periods. I’m conservatively estimating an ASP of about $620 on the quarter to partly account for the slight hit Apple will take for the free bumper program. Thus, based on sales of 11.5 million units at average selling price of $620, I’m expecting Apple to report about $7.13 billion in iPhone revenue on the quarter. See the charts below. (click to enlarge)

Macintosh Unit Sales & Revenue
Macintosh unit sales and revenue is significantly easier to predict for the September quarter, and once Gartner data is released, we’ll get a clear idea of what one should expect to see in Q4. Again, the sequential and yearly growth trends both suggest that we should see unit sales fall somewhere in the range of 3.8 to 4.0 million units.

Taking a look at the sequential seasonal growth rate between Q3 and Q4, Apple generally tends to post significant percentage gains largely due to the back to school shopping season. Last year, for example, Apple reported a 17.3% sequential rise between fiscal Q3 and Q4. Yet, in 2008, Apple saw a much lower sequential rise of 4.6% due largely to slower sales as a result of the impact of the financial crisis. However, I think last year’s sequential growth rate provides a more reliable basis for forecast in light of the more stable economic environment. Thus, based on the 17.3% sequential rise between fiscal Q3 and Q4, it is possible that Apple may ship around 4.1 million units this quarter.

Moreover, the current yearly growth rates of Apple’s most recently report three quarters seems to support this view. For Q1 2010, Apple posted Macintosh unit sales growth of 33.2%. For Q2, it reported 32.8% and for Apple’s recently reported fiscal Q3, it recorded sales of 33.4%. Notice how the year over year growth rate has consistently fallen within a range of 32% to 33% for each quarter this year. Thus, if the trend continues and Apple sees a 33.4% year over year rise in Macintosh sales, it’s probable that Apple can post sales of approximately 4.06 million Macintosh computers this quarter.

So while I’m currently modeling for sales of 3.8 million Macs, I believe that once Garter and NPD data is released in October, I will likely be upgrading my assessment of Macintosh unit sales before Apple reports its results. It’s also prudent to be somewhat conservative with initial forecasts in order to leave room to raise estimates in the future.

Using the same methodology to forecast unit sales growth, one can easily predict Macintosh ASP. In fact, it’s even easier to forecast average selling prices than it is to forecast unit sales. When forecasting the September quarter, it’s important to understand that two key issues will likely negatively impact Macintosh average selling prices. First, that Apple offers rather aggressive discount incentives and promotions to students buying a Mac during the back to school shopping season. Secondly, there’s a general shift from sales of Apple’s higher end offerings to lower priced Macs during the quarter. So what we generally witness is a slight decline in ASP between fiscal Q3 and fiscal Q4.

Yet this isn’t always the case. Often times we’ll see Q4 Macintosh ASPs be flat to slightly up on the quarter. The strength of the dollar or Euro weakness also tends to have a big impact on the sequential comparison of Macintosh ASP. In fact, recent weakness in the dollar during the month of July portends a potentially stronger Macintosh ASP than what Apple reported in fiscal Q3. Still, for the sake of conservatism, it’s not a bad idea to model for a slightly lower average selling price than what might be suggested by the weaker dollar. If the dollar continues to weaken throughout the quarter, then I could easily upgrade my assessment of the average selling price.

Based on these considerations, I’m modeling for an average selling price of $1,250 on the quarter. That’s just $17 lower than what Apple reported in fiscal Q3. Thus, based on a forecast of 3.8 million unit shipped at a $1,250 ASP, I’m generally looking for Apple report about $4.75 billion in Macintosh revenue this quarter. Yet, as we noted above, it’s possible that once we get all the relevant data, a forecast of over $5 billion in Macintosh revenue might be more appropriate. The two charts below outline Macintosh unit sales and average selling prices from 2006 to the present. (click to enlarge)

iPod Unit Sales & Revenue
iPod unit sales were very disappointing in Q3, and it makes it difficult to gauge how well they will sell in Q4. Yet, I did note in two different articles that iPod sales as a percentage of Apple’s total revenue has been on a consistent decline since 2006. That the market doesn’t give much of a crap about how iPod unit sales fare anymore (this was proven true by the mere fact that the market brushed aside the huge miss in unit sales during Q3), and that Apple’s reliance on the device as a driver of revenue isn’t as important as it once was in the past. See here and here.

In fact, revenue from the device formed only a tiny portion of Apple’s total revenue in Q3 as it only accounted for merely 9.8% of the business. Moreover, iPod fell to the fourth largest contributor of Apple’s overall revenue for the first time in the device’s history in Q3. In its inaugural quarter, even iPad revenue far surpassed iPod revenue in Q3, and iTunes revenue seems to be closing in to push iPod unit sales to fifth place.

Yet, this debate aside, I’m modeling for sales to come in at 10 million units in Q4 as the September iPod refresh looks to revitalized sales on the quarter. It’s not uncommon to see unusually weak iPod unit sales in Q3 from time to time. In fact, Apple reported a similar plunge in unit sales between Q2 and Q3 of 2007 and 2009. Yet, sales did in fact rebound quite significantly in Q4 once Apple released its new lineup of iPods during the last month of the quarter. Thus, we’ll have to wait for NPD data to get a rough idea of what we can expect to see on the quarter.

iPod average selling prices are a much easier variable to forecast. I expect iPod ASP to come in at $158 based on the current seasonal and sequential trend. Thus, based on sales of 10 million iPods at an average selling price of $158, I’m expecting to see roughly $1.58 billion in iPod revenue - just a fraction of what Apple will likely report in iPad, iPhone and Macintosh revenue this quarter. The two charts display iPod unit sales growth and average selling prices over the past several years. (click to enlarge)

iPad Unit Sales & Revenue
I expect iPad sales to pick up quite a bit over the 3.3 million units Apple reported in Q3. As Apple works to meet the current supply-demand imbalance over the next month or so, we’ll probably see a strong run rate in the second half of the quarter. Also, Apple’s newest products tend to do a lot better in terms of sales after their inaugural quarters. Add the benefit of the back to school shopping season and we should expect to see sales come in at around 4.5 to 5 million units. We have very little data in terms of the seasonality for the iPad, but the fourth quarter is generally a strong quarter for Apple indicating that we should see a strong uptick in sales. Thus, based on $650 ASP, I’m looking for Apple to post about $3.25 billion in iPad revenue this quarter.

iTunes Revenue
iTunes revenue continues to consistently grow over the quarters making it relatively easy to forecast. Usually, iTunes revenue tends to be flat sequentially between Q3 and Q4 yet I think Apple will benefit from higher activity from strong sales of the iPad on iPhone 4. I’m modeling for a slightly higher sequential rise in iTunes revenue than what Apple has seen in the past. Moreover, though iTunes revenue growth has tended to be flat from Q3 to Q4 in the past, in 2009 we did see quite a bump in revenue despite the prior trend. Thus, I’m expecting iTunes revenue to come in at $1.275 billion or slightly above the $1.214 billion apple reported in Q3. See the chart below. (click to enlarge)

Peripherals Revenue
In terms of peripherals revenue, what we tend to see over the past two years is a steep decline in peripherals during Q3 followed by a steep rebound in the September quarter. I’m basically looking for that same seasonal trend to continue, and I’m modeling for revenue to jump to $450 million this quarter. That compares to the $396 million Apple reported in Q3. (click to enlarge)

Software Revenue
Software revenue is slightly easier to forecast than peripherals. What we get is nice consistent software revenue growth and a peaking in fiscal Q4. With the exception of the occasional operating system release, Apple’s Q4 software revenue has tended to slightly outperform the previous three quarters. See the chart below. Thus, based on the trend in software revenue, I’m modeling for Apple to report $670 million in fiscal Q4 versus the $646 it reported in Q3. (click to enlarge)

II. THE INCOME STATEMENT
Now that I’ve laid out the details of how I arrive at my $19.1 billion revenue estimate for Apple’s September quarter, the sections below will go through and discuss line items in my income statement model to arrive at $4.45 in EPS.

Revenue, Gross Margin & the Cost of Goods Sold
Gross margin is the amount of money Apple makes on each of its products less the cost it takes to make those products. The only costs considered are the manufacturing cost, the bill of materials, and the packaging cost. These costs are called the cost of goods sold or ‘COGS.’ Subtracting the total cost of goods sold from Apple’s overall revenue will give you Apple’s gross margin.

Determining what Apple’s total gross margin will be in any one of Apple’s fiscal quarters requires an understanding of which of Apple’s product tend to carry higher gross margins, a careful analysis of Apple’s guidance for gross margin, the seasonal trend, the strength of the U.S. Dollar relative to the Euro, and whether a newly introduced product carries a higher or lower gross margin relative to the company’s average.

Apple’s management has repeatedly noted that the iPad tends to carry a lower gross margin due to the company’s strategy to aggressively price the product in a way that is very competitive relative to the industry. Based on this and other considerations, Apple guided gross margins down to 35% from the 39% it reported in fiscal Q3. Yet, it’s important to note that Apple tends to be overly conservative with its gross margin guidance. In fact, Apple beat its gross margin guidance by over 300 basis points last quarter.

The table below compares Apple’s gross margin guidance to its actual results. Please keep in mind that in order to get an accurate reading of Apple’s guidance behavior, it’s important to refer to Apple’s pre-amended quarterly results. Starting in Q1 2010, Apple changed its GAAP revenue accounting system for the iPhone and has thus amended every quarterly report since fiscal Q3 2007 to reflect this change. Yet, there’s no point in comparing Apple’s guidance to amended results because in order to analyze Apple’s guidance behavior, one has to compare their guidance to the original results for which their guidance was originally intended. Any time I analyze Apple’s guidance behavior, I’ll be referring to pre-amended results for any quarter that was eventually amended. Obviously this doesn’t apply to fiscal Q2 – Q4 of 2010. (click to enlarge)

Moreover, for the past two years, Apple’s September quarter has tended to outperform its fiscal Q3 on the gross margin front. This is largely due to the sizable uptick in iPhone sales which tends to carry a larger overall gross margin than Apple’s other products. Yet, at the same time, with an expected rise in iPad sales on the quarter, I’m expecting to see a slight decline in overall gross margin sequentially. Even Apple’s gross margin guidance for Q4 was 100 basis points less than its gross margin guidance for fiscal Q3. Thus, based on all of this data, I’m modeling gross margin percentage to come in at around 38.75% versus the 39.08% Apple reported in fiscal Q3. Thus, I’m looking for Apple to report about $19.105 billion in revenue, 11.702 billion in the cost of goods sold and $7.403 billion in gross margin. (click to enlarge)

Operating Expenses & Operating Income
Operating expenses include those expenses related to running the Apple operation. The geniuses at the Apple store, Steve Jobs’ $1 income, the rental cost of all of Apple’s retail stores, the employees, the paperwork, the Apple campus in Cupertino and all other money spent to run the company are operating expenses. Based on the current trend in Apple’s guidance, one can produce a pretty reliable picture of what Apple will probably report in the September quarter.

There were several quarters where I was able to forecast these expenses almost perfectly because Apple would regularly guide $40 million under the actual results. Picking up on this trend, it has been relatively easy to predict these expenses. Yet, one must also consider the growth trend of these expenses to help facilitate a strong forecast. The chart below compares Apple’s guidance for operating expense to actual results. (click to enlarge)

For Q4, I’m modeling for an estimate of $2.050 billion in operating expenses based on Apple’s guidance, and based on the trend. Knowing that Q4 tends to be one of the highest quarters in terms of operating expenses due to Apple mass hiring to meet consumer demand of the iPhone and back to school shopping season, I’m expecting a $150 million bump to $2 billion in Q4. The chart below outlines Apple’s operating expenses from 2006 to 2010. (click to enlarge)

To arrive at operating income, income that Apple generates from its primary operations, one must simply subtract operating expenses from gross margin. Remember operating expenses are those expenses that only include the costs to run the entire Apple operation. Gross margin, on the other hand, is the amount of money Apple makes on the sale of each of its goods (revenue) minus the cost it takes to bring those goods into existence i.e. to make those goods. Thus, for Q4 I’m forecasting an operating income of $5.353 billion, which is the difference of subtracting $2.050 billion in operating expenses from $7.403 billion in projected gross margin.

Other Income & Expenditures
Companies will regularly make and/or lose money on the sale of property, from interest on their cash deposits, or from investments. Good accounting requires that we keep that income or loss in a separate category because it would be inappropriate to suggest that income from an investment should be part of the income that Apple receives from the sale of its goods.

So under generally accepted accounting principles (GAAP) we have a line item in the income statement called “Other Income & Expenses” or OI&E. Though the dollar amount of OI&E is generally a small amount compared to Apple’s operating income, it can and will regularly affect EPS and so it should be taken seriously. Based on Apple’s guidance, which generally undercuts or overstates OI&E by about $5 - 10 million, I’m projecting OI&E to come in at about $55 million for Q4. The table below compares Apple’s OI&E guidance to actual results for the past several years. (click to enlarge)

Net Income, before appropriations for income taxes
Finally, to arrive at income before a provision for income taxes, one only needs to add operating income to OI&E. In this case, I’m expecting $5.922 billion in operating income, and $35 million in OI&E for Q4. Thus, we arrive at a net income before taxes of $5.957 billion.

The Tax Rate
Last quarter many of my readers were quick to criticize my tax rate estimate despite my long history and track record following Apple. I had a tax rate guidance of 23.6%, which while slightly lower than the reported 24.2% tax rate, was far more in-line than the 27% suggested by many of those criticizing my aggressive tax forecast. Some of my readers even harped on Apple’s comments that fiscal Q2’s low tax rate was just a one-time thing, and that it was nuts to model for an aggressively low tax rate for Apple fiscal Q3 and Q4 in my analysis.

Well if there’s one thing I learned from following Apple’s guidance over the years, it’s that rarely is any benefit just a one-time thing and that’s Apple’s fiscal Q4 tax rate is generally lower than that of Q3. That’s why I had a low tax rate in my initial Q4 estimates when I published them about a month ago. And as I expected, Apple’s tax rate guidance for Q4 is the lowest in the company’s history! In the future, I would appreciate it if my readers would just trust me so I don’t have to write a dissertation explaining my methodology every time I draw up estimates for Apple. In fact, this will be the last time I go into such detail. In the future I’ll just publish the estimates and refer to this article for the methodology.

The table below compares Apple’s guidance to their actual results over the past several years. Notice how Apple generally guides way above what it tends to report in taxes. Based on the trend in Apple’s tax guidance, I’m modeling for a 23% tax rate on the quarter. (click to enlarge)

Net Income
Thus, based on a tax rate of 23.0% for Q4, I’m looking for Apple to record a post tax profit of $4.164 billion in fiscal Q4. Apple will also probably generate more or less that amount in cash.

Earnings per Share
Once you arrive at net income, the job is basically done. One only needs to divide net income by the number of projected outstanding diluted shares to arrive at Earnings Per Share or EPS. Based on a projection of 930 million shares outstanding at the end of Q4 2010, my estimates are calling for Apple to report $4.45 in EPS on $19.105 billion in revenue versus the current consensus of $3.95 in EPS on a conservative $18.29 billion in revenue.

Disclosure: At the time of this writing, the author holds September $45.00 puts on the QQQQ. The information contained in this column is not to be taken as either an investment or trading recommendation, and serious traders or investors should consult with their own professional financial advisors before acting on any thoughts expressed in this publication.

Broader Market ETFs Set Up for an Easy Trade this Week

2010-08-02T22:12:00.000-07:00

Yesterday’s explosive rally has set up the index-pegged ETFs for an easy short-term trade this week. The trading range on the entire July rally has formed a text-book rising wedge on the indices, and the ETFs continue to bounce seamlessly off the lower and upper trend lines.

Last week I made a few highly profitable trades by shorting the QQQQs at the upper trend line via August puts, and covering that position at the lower trend line. Yet, the same trade can be made on the SPY and DIA, but I choose to trade the cubes due to the more reasonably priced short-term options.

This week, we’re seeing a very similar set up as the market approaches the upper trend line. In fact, I have already assumed half my position at the close yesterday in light of short-term overbought conditions, and to get ahead of any potential premature breakdown of the trend as we approach resistance. Here’s how the basic trade sets up under a few different scenarios.

Scenario 1: If the market hits the upper trend line as anticipated, I’ll be taking the other half of my September $45.00 puts on the quad-Qs. I’ll hold that full position until the market pulls back to the lower trend line of the rising wedge. I’ll automatically sell half of my position at the lower trend line, and see how the market trades at its 1-month support line.

If the market breaks down below the wedge line, then I’ll hold my remaining position as I think such a breakdown likely signals a retest of the correction lows. If, on the other hand, the market bounces off the lower trend line, then I’ll dump the other half of my position at the first sign of strength in the markets. The whole trade from upper trend line to lower trend line is likely a two-bagger. (Click to Enlarge)

Scenario 2: Now lets suppose the market doesn’t even make it to the upper trend line permitting me to take the second half of my position. In this scenario, I already have the first half of my position I took at the close yesterday thus allowing me to participate in the trade. That’s why its key in these scenarios to take half of the position near the top of the trading range rather than waiting for the market to rally to the exact top of the upper trend line.

So now that I have at least half of the position I originally wanted I can profit from the pull back by holding to the lower wedge line. In this scenario, I’m still going to sell half of my position and analyze how the market trades at the support line. If it fails the support line, I’ll hold for a 3-5 bagger. If it rallies off support then I sell that other half position for an overall very healthy gain. (Click to Enlarge).

Scenario 3: Whenever taking any position in the markets its also always important to remember that losses often can and will happen from time to time. So in this scenario we consider loss mitigation. Lets suppose that the market reaches the upper trend line as expected, and that after taking the second half of my position the market breaks out above the upper trend line on convincing volume.

Under this set of circumstances, I’ll immediately dump my puts for a very small loss. Yet, if the market break above the upper trend line on very unconvincing volume or on sideways action indicating an attempt to shake out the shorts, then I’ll taper down my position to the original half and continue with the trade until I see a clear break. (Click to Enlarge).

These are basically the three scenarios I see playing out from here making this trade a really easy set up to take advantage of the day to day fluctuations in the market. As I noted above, the same trade can be made on the SPY and DIA as the same rising wedge is set up on both of those ETFs as well. Happy trading.

Disclosure: At the time of this writing, the author holds September $45.00 puts on the QQQQ. The information contained in this column is not to be taken as either an investment or trading recommendation, and serious traders or investors should consult with their own professional financial advisors before acting on any thoughts expressed in this publication.

Warning Signs Suggest Market Headed for Another Collapse

2010-08-01T17:32:00.000-07:00

In early January 2008, I had a very troublesome conversation with my colleague at Matrix Analytix regarding a significant warning sign suggesting that a major crisis loomed on the horizon of the equity markets that year. The content of our conversation was focused on the implications of a massive one-year head & shoulders on the S&P 500 (SPY). The issue consistently pervaded my mind because if what the equity markets seemed to signal was true, we were probably headed for a major collapse. I remember asking him specifically, “Can this be for real? What are the implications of a head & shoulders of that magnitude completely unwinding?”

My colleague all but confirmed my concerns even pointing to a potential culprit for the impending downturn. He had noted that the markets had all but brushed off early warnings of systemic risk and liquidity concerns posed by the potential failure of subprime MBS’s that August, and that such concerns were likely to resurface in 2008. I, for one, didn’t really care what the potential culprit may be. For me, the fact that market technicals suggested that an impending failure was drawing near formed the basis of my concerns.

The fact that market participants, investors, and the mainstream media continued to put their heads in the sand and ignore such blatant signs of the broader market was simply unacceptable. At the time, the S&P 500 had rallied nearly 35% over the past 2 years. There was rampant discussion of Dow (DIA) 18,000 as the market continued to “benefit” from the so-called “Goldilocks economy.” Almost everyone was either oblivious to the warning signs of the broader market or simply decided to ignore them.

Turn the page to today, and it’s the same story all over again. While investors, fund managers, and the mainstream financial media debate whether we’re headed for a double-dip recession, they simply continue to disregard the obvious technical damage done on the broader market. Once again, this article is not so much concerned with the potential fundamental reasons or theories advanced as to why the markets might unravel. Instead, I’m more concerned with what the broader market seems to be telling me about the immediate future.

One can find no shortage of fundamental or mechanical theories explaining what might form the basis of a future financial collapse published at Zero Hedge, by Nassim Nicholas Taleb, Nouriel Roubini or Karl Denninger. In fact, I buy into a lot of the evidence presented by these sources, and believe that one gains a better grasp of financial reality spending 10 minutes with Zero Hedge than spending 2 weeks listening to the mainstream financial media. It is laughable to compare the vacant dribble coming out of Dennis Kneale to even one single article published by Tyler Durden or Ryan Iskander.

Once again, right now I’m focused on what the trading activity in the broader market seems to be telling me rather than on what the fundamentals of the economy or the mechanical structure of the markets indicate. The techncials suggest, as they did in early 2008, that there is something fundamentally wrong with the financial markets and that a collapse, whatever the fundamental reasons may be, is potentially drawing near. There are seven issues I’ll briefly discuss below, and why its imperative that my readers should explore these issues in more detail.

1. Head & Shoulders on the S&P 500, Dow Jones, and NASDAQ
The biggest warning sign the market seems to be giving us right now is the blatant 10-month head & shoulders formation seen on each of the major indices. Like in 2008, a massive head & shoulders of this magnitude is not something that investors ought to take likely. Millions chose to ignore this warning sign in 2008 at their peril. I’m not going to sit here and belabor the point as I’ve already written extensively on this topic, which could be found here.

Yet, to summarize, a head & shoulders formation is arguably the most bearish technical formation in the books. The time, breadth and size of this head & shoulders is exactly the same as what we saw in early 2008 just before entering the biggest bear market in modern history. The neckline on this formation sits at around 1040 on the S&P 500. A substantial break below 1,000, the low of this current correction, could spell disaster for the broader markets. This is something worth watching. The long-term prospects of the market are completely in question until we see a rally above 1,220 on convincing volume.

2. Bullish Flag on the VIX?
Almost as important as the head & shoulders on every broad market index and exchange is the huge bullish flag on the VIX, $VXN and VXX (VXX). Volatility looks like its about to explode higher in the September to October time frame. A convergence of the upper and lower trend lines appears to take place near the end of August. This certainly does not bode well for the markets. An explosion of volatility can only be viewed as conclusively negative for the markets. We can’t have a massive spike in volatility without a coinciding collapse in the equity markets.

Yet, at the same time its possible that volatility can break out to the down side. A collapse in volatility could be very positive for a more stable equity market. It’s not uncommon to see bull flags fail to the down side. Still, a bullish flag is generally an indicator of higher price action in the future. Thus, one who chooses to ignore the obvious warning signs suggesting that we’re headed for bouts of high volatility in the near future does so at his or her peril.

3. The Death-Cross on the S&P suggests the 2009 to 2010 Rally might be Over
This topic has already been written about quite extensively over the past few weeks. As you may or may not be aware, the 50-day moving average crossed under the 200-day on the S&P 500 signaling that the March 2009 to April 2010 bull market might be at an end. When the 50 and 200 days cross in this manner, it suggests that the overall trend has weakened to such a degree that the recent price action is viewed as a topping process for the markets. We saw this exact same bearish cross on the S&P 500 in early January 2008 right at the start of the great bear market. You can read more about the death-cross here, here and here.

4. The Volumeless Rally & Mutual Fund Outflows
Arguably one of the biggest warning signs suggesting that the entire 2009 to 2010 advance is just a bear market rally arises from the fact that the move was done on increasingly less volume. The clear lack of conviction indicates that the move was orchestrated by very few market participants. Some have advocated that the 2009 to 2010 rally was performed under the completely control of the federal reserve or by high frequency traders in either a ploy to combat deflation or by fixing the odds of the market to favor the very few. If Goldman Sachs posting gains every day in Q1 isn’t enough evidence that the game is fixed, I don’t know what is.

Every down move in the market is done on massive volume, and every up move on little to no volume. Each day of the February to April melt-up rally was easy to predict. When volume tanks, the market rises and volume picks up, the market tanks. What kind of no-conviction fraudulent market rallies on zero volume and tanks on heavy volume? Even the July bounce to this correction was done on low volume. Down days in July exhibited huge volume while up days saw declining participation.

This lack of conviction in the equity markets is further evidenced by the disconcertingly significant mutual fund outflows seen over the past year. Tyler Durden notes in an article posted at Zero Hedge last week, “The latest update from ICI is a doozy: in the week ended July 21, domestic equity mutual funds saw a 12th sequential outflow of $1.5 billion. Even as the market has surged 10% in the last three weeks, just under $10 billion have been redeemed from mutual funds, completely invalidating the move and further justifying the skeptics who see absolutely no reflection to reality in the volumeless ramp orchestrated by a few momentum HFTs and a couple of Primary Dealers with some excess leftover Discount Window change. Not to mention that 12 weeks in a row of outflows pretty much marks game over as far as retail participation is concerned in stocks."

Thus, until I see volume start to pick up during these July-type moves in the market, every indication suggests that the 2009 to 2010 rally in general, and the July rally in particular is complete horseshit. At the very least, there is overwhelming evidence indicating that something is broken in the pricing structure of the markets, and it will either have to work itself out through a minor collapse like the 2008 financial crisis, which could potentially bring in some real participation at distressed levels; or the markets will continue to move forward as they are and increase the risk of a real system collapse of the world financial markets.

5. 1,000 Point Flash Crashes
Adding to the concerns of low volume and mutual fund outflows, if 1,000-point inter-day swings in the Dow doesn’t raise a clear red flag to investors that the mechanics of the market is under fire, then clearly nothing can convince the average investor to consider caution in the coming months. Whether the so-called “flash-crash” was the result of some questionable “fat-finger” trade or the result of everyone putting in stop losses at the same level on the S&P (which I warned about 7-minutes prior to the crash see here) is anyone’s guess.

The fact that it occurred at all is by itself a cause for concern. There was apparently no fundamental reason behind the crash. Just 15 days earlier, the market was all honky-dory with its volumeless record rally, and so that inter-day crash can be attributed to a breakdown in market structure.

Yet, that breakdown is ongoing and has been ongoing as indicated by the backwards market that continues to rally on no volume and sells-off on heavy volume. The market technicals are telling us that its very possible that we could see another permanent flash crash sometime within the next few months. As we head into traditionally the weakest months of the year for the financial markets, only the profoundly fearless is very long this market. One who enters October 2010 very long shouldn’t be surprised if their account experiences cardiac arrest.

6. Bond Market Distrustful of the Rally
While the equity markets have rallied in July, the Bond market continues to be distrustful of this move in equities. Just on Friday, there was a complete decoupling between the move in the bond market and the move in the equity markets. Though the stock market rallied from its lows to close nearly flat on the day, yields continued to weaken and the TLT rallied into the close.

The $TNX, an index of the 10-year note yield, fell a whopping 3% on the day, all while equities closed flat! The $TNX traded near the lows session while equities rallied off their lows turning flat at the close. The TLT (TLT), which is a 20-year bond fund, not only gapped up at the open, but it closed near the highs of the day completely invalidating the move in the equities markets. The $TNX is sitting at a near 4-month low, the TLT at a near 4-month high, and yet the equity markets rallied nearly 10% in July? Something is clearly wrong with the equity markets.

7. Market Leadership is Weakening
Technology stocks (QQQQ), the market leader during the 2009 to 2010 recovery, continue to underperform the broader market. Apple (AAPL), the captain of the recovery, has reported two back-to-back blowout quarters yet continues to trade sideways to down over the past 4 months. Neither fiscal Q2 nor fiscal Q3 earnings reports have lead to any advances in Apple’s stock price suggesting that market leadership is starting weaken. Instead of leading the market higher, Apple, Microsoft (MSFT), Google, (GOOG), Intel (INTC), Cisco (CSCO) and other large cap bellwethers have been following, rather than leading the broader market. While Apple specifically has held up remarkably well in this correction, it barely participated in the July rally. In fact, industrial names have been leading the market lately, which is generally not a good sign for the overall market.

While this article lays out a very grim picture of the equity markets going forward, its important for investors to realize that the markets have rallied against bearish technicals in the past. Yet, the odds clearly favor the bears from a technical standpoint. A head & shoulders, while not bearish 100% of the time, is generally bearish most of the time. Unless you’re Goldman Sachs (GS) or J.P. Morgan (JPM), the most you can hope for is to bet with the odds. Right now, the probability suggests that the market is at very dangerous levels. Enough so that I’m generally either short the broader market or all cash.

Yet, those who know me know that I’m generally not a bearish journalist. I’m very neutral with respect to the markets. If the evidence weighs in favor of the upside, I’ll be long this market. In fact, I have traded calls a handful of times for some very handsome gains during this past correction. I’m neither a fan of the bulls nor a fan of the bears. I’m a fan of the evidence.

The most important thing I learned from spending three years at one of the forefront law schools in the country is that I have no opinions at all. That only the dictates of evidence should determine how I’m positioned in law or equity (no pun intended). At the same time, the facts are constantly changing, and if later evidence indicates that the coast is clear, you’ll be the first to see a long disclosure at the bottom of my articles. Yet, until that time, I would tread very carefully.

Disclosure: At the time of this writing, the author holds no position in the equity markets. The information contained in this column is not to be taken as either an investment or trading recommendation, and serious traders or investors should consult with their own professional financial advisors before acting on any thoughts expressed in this publication.

Equity Market Ready to make a Massive Move

2010-07-27T11:44:00.000-07:00

There are several key technical indicators suggesting that the market is ready to make a massive move one way or the other, and the evidence is pretty compelling on both sides of the tape - though I think the bears have an edge here. Yet, one thing is for sure. Whichever way the market goes, it will be a big move in the coming weeks. (QQQQ) (SPY) (DIA)

We're either going to see a February to April type melt-up or another huge downdraft to at least test the correction lows. I suspect this move will begin within the next few trading sessions. I'm currently positioned on the short side of the trade, however, to take advantage of very overbought conditions as exhibited in the NYMO and cumulative tick.

The Bear Case
There are four central technical indicators suggesting that this current rally is on its last legs, and the market is about to see some major selling pressure starting within the next few trading sessions.

First, the $NYMO is simply way too high. In fact, its sitting at levels not seen since the bear market lows set over a year ago. An 80 on the $NYMO usually indicates that the market is getting a little over extended - it current sits at 97.25 set at yesterday's close. You can see a very thorough analysis on the $NYMO at Cobra's Market View.

Secondly, the cumulative tick on the NASDAQ has hit levels suggesting that a major sell-off sits on the horizon. The last 11 times we saw such overzealous buying on the NASDAQ a significant sell-off in the markets followed within a few days. See Cobra's Market View or SentimenTrader for more on the cumulative tick indicator.

Thirdly, the last two trading sessions of the last nine or so months have generally been met with significant weakness. Those who have shorted the broader market at the close of the third to last trading session, and covered that position at the close of the last trading session has been very profitable for nearly every month of the past year. See here.

Finally, the volume on the market's recent move up through several key technical levels of resistance has been very abysmal. This indicates a serious lack of conviction on the part of market participants taking this market higher. The S&P 500 closed above the 200-day moving average yesterday on very weak volume, and continues to flirt with that level today but without the necessary conviction to bring real buyers into this market.

The Bull Case
The bulls have some very compelling arguments of their own. First, recent weakening of the trend on the TLT (TLT) seems to indicate that there may be an impending flight from the safety of fixed income instruments to the higher risk assets in the equity markets. The TLT appears to have put in a double top at around $102 and is currently flirting with the 50-day moving average. There's an inherent inverse relationship between the TLT, a 20+ Year Treasury Bond Fund, and the equity markets.

Secondly, the $TNX (10-Year Treasury Note Yield Index) seems to support this view as it appears the yield on the 10-year treasure note has put in a double bottom at the 29 level. Moreover, the $TNX is currently testing the upper trend line of the April to July downtrend suggesting that market participants are getting ready to shift to an equity strategy.

Thirdly, the $VIX is at the cusp of breaking down from the April to July bearish pennant, and appears that its set to close below the 200-day moving average for the second day in a row. A shift to an equity environment of lower volatility will clearly be conducive to much higher stock prices.

For a more detailed analysis of the equity markets, please see Cobra's Market View - easily one of the best technitions I've had the pleasure to follow over the past several months.

Disclosure: At the time of this writing, the author holds August 2010 puts on the QQQQs. The information contained in this column is not to be taken as either an investment or trading recommendation, and serious traders or investors should consult with their own professional financial advisors before acting on any thoughts expressed in this publication.

Barron's on Apple & Microsoft

2010-07-24T11:24:00.000-07:00

One of my favorite columnists, Eric Savitz, published a well-balanced piece comparing Apple and Microsoft in Barron's today. Its definitely worth a read. He captures, what I think, is a very key concept when assessing these two companies - that one is a value play and the other a growth stock. As I noted in an article I published at Fortune this past Monday, I'll be running an in-depth comparative analysis of these two companies in the coming weeks.

While some regard Eric as generally bearish or skeptical on Apple, I've had a chance to follow a lot of his writing over the years and can attest that those concerns are relatively overstated. He's actually very balanced and fair in his writing focusing on both the positive and negative aspects of the company.

As most of wall street and the media seems to place Apple on a pedestal, I think it's important to keep in mind that there are always two sides to every story, and Eric does a excellent job of reminding us of this. You can read Eric's article here.

Disclosure: At the time of this writing, the author holds August 2010 puts on the QQQQs. The information contained in this blog is not be taken as either an investment or trading recommendation, and serious traders or investors should consult with their own professional financial advisors before acting on any thoughts expressed in this publication.

Apple to Surpass Microsoft in Revenue this Quarter?

2010-07-21T18:31:00.000-07:00

After 30-years of living in the shadows of Microsoft, Steve Jobs and Co. will likely surpass its archenemies in Revenue this quarter. And as Apple’s staggering growth rate continues, its unlikely that Microsoft will be able to resume its dominance over the iPhone maker anytime soon.

While doubts as to whether Apple (AAPL) deserves to hold the second largest market cap in the U.S. continues to mount, one thing it is clear: Apple has closed the revenue gap on Microsoft (MSFT), and looks to assume full supremacy over the software giant going forward.

And though Apple still has a ways to go to compete with Microsoft in terms of net income due to Microsoft’s stunning operating margin, many will be surprised to learn that Apple will actually post more revenue than its rival in the 2010 and 2011 fiscal years.

In fact, when Microsoft reports second quarter calendar results after the bell this afternoon, its likely that Apple will have surpassed Microsoft in revenue for the first time in the company’s recent history - and that it will continue to do so in the future. Apple reported $3.25 billion in net income ($3.51) on a whopping $15.7 billion in revenue on Tuesday, smashing analyst expectations, and reporting more or less in line with my forecast.

Microsoft, on the other hand, is expected to earn $4.1 billion in net income ($0.46 in EPS) on $15.26 billion in revenue when it releases results after the bell today. That is nearly $500 million less than what Apple reported in revenue this quarter. And while Microsoft also regularly reports upside surprises making it very possible that it could edge out Apple in revenue, the gap between consensus estimates and Microsoft’s actual results is nowhere near as wide as it is with Apple’s results.

The chart below details a quarterly revenue comparison of Apple and Microsoft over the past few years. As one can see from the chart, Apple looks to surpass Microsoft’s quarterly revenue for the first time in recent history. More importantly, while Microsoft’s revenue growth appears to have slowed in recent years, Apple continues to post one record quarter after another. Since Microsoft and Apple are on a different fiscal year, the chart realigns their results to make them comparable on the calendar year.

So the big story in tech earnings this week is whether history will be made in the decades-long battle between Apple and Microsoft, or whether Microsoft will postpone the inevitable and maintain its dominance over Apple for at least one more quarter.

And even if Apple doesn’t beat Microsoft in sales this quarter, it will certainly do so next quarter and by quite a large margin. For the September quarter, analysts expect Apple to generate approximately $18 billion in revenue compared to a projected $15.16 billion expected out of Microsoft.

So even conservative analyst estimates already put Apple ahead of Microsoft by nearly $3 billion next quarter. My estimates put Apple ahead by $3.8 billion as I expect Apple to record nearly $18.9 billion in revenue. You can see my track record on Apple here.

What’s even more surprising is that Apple will likely far surpass Microsoft in revenue for the entire 2010 and 2011 fiscal year. In fact, I’m looking for Apple to record $81.6 billion in revenue in 2011 – that’s about $11.6 billion above the $70 billion I’m expecting out of Microsoft. Even the 2010 and 2011 conservative analyst consensus puts Apple well ahead of Microsoft. Thus, it’s looking increasingly likely that this quarter sets the beginning of a new age where Apple will regularly post higher revenue than Microsoft going forward.

The chart below compares Apple and Microsoft’s annual fiscal revenue for the past several years. While quarterly data must be compared on the calendar year to show a side by side comparison over a particular 3-month period, yearly data can be analyzed on the fiscal year.

Yet, when it comes to questions as to which company ought to have a larger market capitalization, total revenue is but a single of several factors that should be considered. Net income growth, total net income, total net cash, cash flow, book value, total assets and the economic sensitivity of each company’s primary operations are just a few of those other key factors.

So while Apple will be surpassing Microsoft in revenue in the near future, that in and of itself doesn’t necessarily mean that Apple automatically ‘ought’ to have a larger market capitalization.

Though under closer scrutiny one will find that within the next year or so, Apple will soon not only record more revenue than Microsoft, but will earn more in net income, generate a larger amount of cash, and out-pace Microsoft in terms of growth in net income and revenue.

Still, Apple does have a ways to go before it will surpass Microsoft in net income. Due to Microsoft’s extraordinarily high operating margin, the only way Apple can beat Microsoft in earnings is by simply outpacing it in sales. Since Microsoft pushes more of its revenue to the bottom line, Apple will have to significantly outpace Microsoft in revenue to win on the net income front – something that Apple will probably do in 2012. The chart below compares Apple and Microsoft’s net income for the last several fiscal years, and offers projections for 2011.

Though these two companies no longer really operate in the same space as they once did in the past, Apple turning its focus on the consumer and Microsoft on enterprise spending, both companies are dominating their respective industries. Yet, several Microsoft investors have argued that it’s somehow inappropriate to compare Apple to Microsoft since Apple is a device maker and Microsoft an enterprise software maker. Nothing can be further from the truth.

Such arguments not only reek of the highest level of financial irrationality, but they are also rooted in a dangerously mislead ideology. Any two companies that make money are automatically comparable.

For while the comparison may or may not be appropriate in a cross sector analysis, any two publically traded companies can in fact be compared on a fundamental return on equity basis. That much is clear. If a multi-trillionaire wanted to buy either of these companies, a fundamental comparison is not only appropriate, but required for sound due diligence.

Moreover, even in a cross sector analysis where an investor wishes to determine which company is best in breed, Apple and Microsoft do in fact participate in the technology sector despite little operational overlap between the two companies. It’s not as if Apple is a pharmaceutical company, and Microsoft an oil refiner. Such is a rudimentary concept of finance, and the average investor would do well to understand it.

Thus, what’s left to be decided is which of these two tech giants deserves to be crowned the supreme leader of the tech sector as a whole? The answer to that question will be addressed in future articles I’ll be writing over the next few weeks. Stay tuned.

See also:
Earnings Smackdown: The best and worst Apple Analysts
Apple Smashes Expectations in its Fiscal Q3 Earnings Report

Disclosure: At the time of this writing, the author holds no position in the equity markets. The information contained in this blog is not to be taken as either an investment or trading recommendation, and serious traders or investors should consult with thier own professional financial advisors before acting on any thoughts expressed in this publication.

Apple Smashes Expectations in its Fiscal Q3 Earnings Report

2010-07-20T16:10:00.000-07:00

Apple absolutely demolished Wall Street estimates posting yet another $1 billion beat on the top line when it released its fiscal third quarter earnings results this afternoon. Shares of the tech giant moved up in after hours as investors welcomed strong results across the board. Apple reported $3.51 in EPS on $15.7 billion in revenue compared to analyst expectations of $3.10 in EPS on $14.74 billion in revenue. Apple also added $4 billion in cash to its war chest bringing the total just above $45 billions.

Apple's earnings were driven largely by sales of 8.4 million iPhones, 9.4 million iPods, 3.27 million iPads, and 3.47 million Macintosh computers. And in spite of the law of large numbers, Apple posted a high flying 61.4% revenue growth and 74.6% EPS growth when compared to the year-ago quarter.

Yet, the big story in this report is Apple's aggressively confident revenue guidance for the September quarter. I've never seen Apple provide guidance so far above the consensus in the several years I've followed the company.

Analysts were expecting Apple to guide for about $17 billion in revenue for Q4. I was actually expecting to see guidance in the range of $16.8 billion consistent with Apple's habit of guiding below the street's expectations. Yet, Apple came right out of left field and aggressively guided for $18 billion for the September quarter all but indicating that revenue will likely come in at the higher end of $19 to $20 billion. I'll be exploring this issue in far more detail in a full review of the earnings release later this week.

Another big story in this report is whether Apple (AAPL) will surpass Microsoft (MSFT) on the top line for the first time in the company's history. Analysts polled by Thomson Reuters expect Microsoft to report earnings of $0.47 a share on $15.27 billion in revenue. Unless Microsoft far surpasses analyst estimates, Apple's $15.7 billion in revenue appears to have put Apple ahead of Microsoft for the quarter. You can read my full report of this story at CNN Fortune.

I'll be doing a more detailed analysis of Apple's earnings and what it means for Q4 later this week. Stay tuned.

See also:
Apple Fiscal Q3 2010 Earnings Preview
Apple Closes in on Microsoft in Revenue Race
How Apple Maintains Explosive Earnings Growth
Philip Elmer-DeWitt's Apple Earnings Preview

Disclosure: At the time of this writing, the author holds Apple 2012 $300 call options purchased ahead of Apple's fiscal third quarter results. The information contained in this blog is not to be taken as either an investment or trading recommendation, and serious traders or investors should consult with their own professional financial advisors before acting on any thoughts expressed in this publication.

Apple Fiscal Q3 2010 Earnings Preview

2010-07-20T00:41:00.001-07:00

As shares of Apple (AAPL) continue to fall under pressure due to negative market reaction to “Antennagate” and disappointing results from IBM (IBM), investors will now look for earnings to pull Apple out of the doldrums. Analysts polled by Thomson Reuters expect Apple to report about $3.10 in EPS on approximately $14.74 billion in revenue. Furthermore, analysts are generally looking for Apple to sell 8.35 million iPhones, 9.8 million iPods, 3.2 million Macintosh computers, and 3.3 million iPads - see here.

Yet, a collection of nine financial bloggers polled by Fortune Columnist Philip Elmer-DeWitt, and who tend to regularly outperform Wall Street analysts are generally looking for far more impressive results than the street. The bloggers, according to Elmer-DeWitt, are looking for Apple to report about $3.64 in EPS on $15.67 billion in revenue (that’s a $1 billion beat on the Wall Street revenue consensus). The bloggers also expect Apple to report sales of 9 million iPhones, 9.9 million iPods, 3.33 million Macs and 3.32 million iPads.

Yet, based on the data I’ve analyzed over the course of the quarter, I’m looking for Apple to report closer in the neighborhood of $3.70 in EPS on $15.608 billion in revenue. I’m expecting Apple to sell 8.8 million iPhones, 10 million iPods, 3.363 million Macs, and 3.4 million iPads. The first table outlines my estimates relative to the consensus estimates and Apple’s forecast. The second table contains my revenue and unit sales estimates for Apple’s primary operations. Please click on the table for an enlarged image.

The big story this quarter, however, is whether Apple will surpass Microsoft in revenue for the first time in the company’s history. Analysts are generally expecting Microsoft (MSFT) to report $0.46 in EPS on $15.25 billion in revenue this quarter. That’s well below the $15.6 billion that the bloggers are expecting out of Apple when it reports this afternoon. If Apple does in fact report closer to what I’m expecting out of the quarter, then we’ll probably be watching history unfold when Microsoft reports this Thursday.

Though it appears this will be a strong report overall, there are still major risks of which investors should be aware. First, due to the collapse of the Euro this quarter, it’s possible that demand for Apple’s products overseas could have taken somewhat of a hit.

Secondly, it’s also likely that Apple will take a hit on the exchange rate leading to added margin pressure. Yet, Apple did note in its fiscal Q2 conference call that it is generally hedge for any potential future strength in the dollar. Still, it’s unclear whether Apple or any other company could have sufficiently anticipated the rather unusually sharp decline seen in the Euro this quarter due to the European sovereign debt crisis.

Another significant risk in this report is that Apple may potentially miss the street’s expectations on iPhone sales. Though the iPhone saw exceptional sell through in the quarter at the retail level indicating high demand for the device, Apple has been very slow at replenishing its channel inventory.

Financial Alchemist’s Turley Muller, who is generally known to be the most accurate analyst covering Apple, is modeling for an iPhone number well below the street. Muller expects Apple to report 7.8 million iPhones due in large part to stress in the channel - that’s 500,000 units below the street’s view. In fact, I’ve reduced my initial estimates from 9.3 million iPhones to 8.8 million units due to channel weakness.

If Apple does in fact miss on the iPhone number, it’s almost certain to lead to a major sell-off in the stock. It’s relatively easy to predict how the market will react to such news. The average fund manager, not fully understanding the difference between weakness in the channel and weakness in demand will see a low iPhone sales figure as simply being weakness in demand.

The market would likely dump the stock in spite of evidence suggesting that sales to the end user have actually been booming throughout the quarter clearly signifying robust demand for the device. The ongoing “antennagate” backlash also doesn’t help matters either. With Research in Motion (RIMM), Nokia (NOK), and Motorola (MOT) passionately attacking Steve Jobs’ attempt to deflect the reception problem of the iPhone 4 to the industry at large, the media is sure to keep this debate alive – and that’s exactly what these companies want.

Yet, though it’s possible that Apple might miss on the iPhone number due to weakness in the channel, I still think the weight of the evidence suggests that strong initial iPhone 4 sales will likely ameliorate the negative impact from weakness in the channel. And even if Apple does happen to miss on iPhone sales leading to short term weakness in the stock, it will present a good opportunity to dollar-cost average. Especially since weakness in the channel in this quarter will lead to stronger results in future quarters as that channel is replenished over the coming months.

Another story worth following in this report is the strength of Macintosh sales. My analysis of Gartner Research on worldwide computer sales seems to indicate that sales will fall between 3.3 and 3.4 million units. That far exceeds the 3.2 million Macs expected by the street. NPD data generally seems to confirm this view as well.

Finally, the most important issue worth following on the conference call is whether management will be able to provide any color on its plans to correct the current supply-demand imbalance going on with the iPhone 4. Apple is currently faced with major supply constrains not seen since the early days of the iPod Nano.

This is evidenced by Steve Jobs’ comments during antennagate that Apple has only sold “well over” 3 million iPhone 4s as of July 16 – that is tracking way behind analyst estimates for Q4. Apple sold 1.7 million iPhones in its first 3 days of sales, and only 1.3 million over the next 19 days. The run rate over that 19-day period is tracking far behind even the most conservative estimates.

In fact, if that run rate continues throughout the quarter, Apple would only sell 6.5 million units in Q4 – that’s well under the 11-12 million iPhone number expected by many analysts. In fact, I’m currently modeling for 11.5 million units. You can read more about this issue here.

Thus, it will be very important for Apple to address this issue head on in the conference call, and give some type of reassurance that it has plans to replenish its channel in a timely manner. For if this incredibly low run-rate continues for much longer, Apple may become at risk of missing Q4 iPhone sales estimates. As of now, this is merely an issue worth following, and I expect that it will be efficiently addressed given Apple’s incredible track record at problem solving. All in all, this should make for an interesting report.

See also:
Philip Elmer-DeWitt’s Very Exhaustive Earnings Preview
Apple Closes in on Microsoft in Revenue Race
2010: The Year Apple Enters a New Golden Age

Disclosure: At the time of this writing, the author holds no position in the equity markets. The information contained in this blog is not to be taken as either an investment or trading recommendation, and serious traders or investors should consult with thier own professional financial advisors before acting on any thoughts expressed in this publication.

How the Overstated iPhone 4 Crisis forced Apple to Give away Free Bumpers

2010-07-16T12:04:00.000-07:00

During the Apple (AAPL) press conference on Friday, CEO Steve Jobs made several very interesting observations about the iPhone 4 antenna crisis that I remember reading about in passing when the problem first surfaced.

That nearly every smart phone in the market today, including the Blackberry Bold and HTC Droid Eris, can lose its signal if handled in certain ways. That if the phone already has a weak signal, improper handling can push that weak signal over the precipice and lead to a dropped call.

So the question I have is if smart phones generally do in fact exhibit similar signal problems as Steve Jobs and others have suggested, then why is Apple being singled out for a seemingly ubiquitous issue exhibited in several other smart phones? More importantly, why has Apple agreed to give away free bumpers when this seems to be more of an industry-wide problem and not just an iPhone 4 problem?

Shouldn’t other smart phone makers such as Research in Motion (RIMM), Google (GOOG) and Nokia (NOK) be equally criticized and equally required to give away free cases? It seems to me that Apple was forced to give away free bumpers due to negative public opinion suggesting that this reception problem is a design flaw specific to Apple. That the free bumper solution was in essence the cost of negative public relations, and more importantly the cost to alter that negative perception. It also doesn’t help that Consumer Reports in one week, passes the iPhone with flying colors and then flip-flops the next week by essentially flunking the iPhone.

Yet, Apple by its own actions isn’t entirely innocent either. Steve Jobs conceded that the reason this whole problem even surfaced to begin with is because of how the iPhone would drop calls from the false appearance of full bars on the phone. That because of some flawed software algorithm, the iPhone 4 displayed more bars than the phone actually had. So when the average consumer would see their iPhone 4 go from full bars to dropped calls, complaints about a design flaw in the antenna logically followed. Apple, for its part, fixed this particular problem with the iPhone 4.0.1 patch released on Thursday evening.

Jobs also suggests that another reason this problem became front and center in the media was due to the iPhone 4 dropping slightly more calls than the iPhone 3GS. That because the iPhone 3GS had a similar design as the iPhone 3G, many people just used their old 3G cases on their new 3GS phones. This supposedly caused the iPhone 3GS to collectively drop less calls per 100 than the iPhone 4 at launch. So the idea here is because more people had cases on their iPhone 3GS, than they currently do on their iPhone 4, the problem became more apparent.

It seems to me that Apple really stands by this idea that the iPhone reception problem seems to be more of an industry wide problem, and far more overstated than suggested by the media. Steve Jobs also announced that Apple has already sold 3 million iPhone 4s since launch – that’s a million per week run rate or 12 million in Q4.

Jobs also noted that not more than one-half of one percent of complaints to Apple Customer Care concerns the iPhone 4 antenna problem and that in fact, it has received thousands of emails from customers indicating that they have no reception issues. I personally have an iPhone 4 without a bumper and have yet to drop a call. Then again, I don’t live in an area with a weak signal and I’m just one person. If Apple is in fact right that this seems to be a smart phone problem, and not just an iPhone 4 problem, then I can understand Steve Jobs’ frustration today. Then again, I have to ask myself: When is the last time the media has ever blown anything out of proportion?

Disclosure: At the time of this writing, the author holds no position in the equity markets. However, the author recently exited a short position he took at the close of yesterday's trading for a large percentage gain on the QQQQ (August $44 Puts).

2010: The Year Apple Enters a New Golden Age

2010-07-07T15:17:00.001-07:00

In the four years I’ve followed Apple (AAPL) grow from a mere mid-sized tech stock to becoming the second largest corporation in the United States in terms of market capitalization, I never imagined that it or any other company of its size would be able to consistently grow its earnings by well over 50% a year.

While Apple is now larger than Microsoft (MSFT), Google (GOOG), Cisco (CSCO), Hewlett Packard (HPQ) and Intel (INTC), Apple still enjoys the growth rate of small cap tech stocks. A few weeks ago I wrote a detailed article entitled Apple’s $63.5 Billion Revenue Year where I offer comprehensive revenue estimates for Apple’s fiscal Q3 and Q4 of 2010 – a must read for any Apple investor.

This article will pick up where that report left off, and take a look at Apple’s potential 2010 earnings. To get an idea of how deeply Apple continues to penetrate the market, Apple will produce 50% more in sales and 71% more in earnings in 2010 than it did last year. If this growth continues into 2011, Apple will surpass Exxon (XOM) to become the largest corporation in America. Not to mention that it already has more cash than any other company in the United States - $41 billion.

That is absolutely stunning when one considers that Apple recorded a whopping $43 billion in revenue during the 2009 reporting period – almost double the $24 billion it recorded in 2007. While the market continues to generally slobber over the financial prospects of the iPhone and Apple’s business, I think it’s important to step back and examine exactly where Apple’s business stands. We often hear about the strength of Apple’s stock in very general terms. Yet, we rarely get a broad picture of Apple’s past, present and future growth rates.

Not only is Apple accelerating its revenue, it’s pushing more of that revenue to the bottom line. For while its sales are accelerating, the growth in the cost to run the entire Apple operation is barely climbing. This means Apple is becoming increasingly efficient at printing money as it makes more revenue per dollar spent to run the operation. This is something that every company, big or small, could only wish to achieve. It is very difficult to accelerate sales as a large cap tech stock while tempering costs.

Based on the analysis presented below, I’m expecting Apple to report $15.51 in earnings per share (EPS) on an explosive $63.409 billion in revenue in 2010. That compares to $9.08 in EPS on $42.9 billion in revenue in the fiscal year ended 2009. The two tables below outline my revenue and earnings estimates for Apple’s 2010 fiscal year. For those who would like to see my track record on Apple, you can find that record at Philip Elmer-DeWitt’s quarterly analyst review published in his Fortune column ‘Apple 2.0.’

Again, this report will focus on Apple’s income statement based on the revenue estimates I’ve already published. For those who are interested on how I arrive at these revenue estimates, please refer to that article. I will also be publishing a detailed analysis of my Q3 2010 estimates in an earnings preview ahead of Apple’s numbers due out after the bell on Tuesday, July 20, 2010. Thus, to get a full picture of Apple’s 2010 fiscal year, I will present a detailed analysis of how, based on a projected revenue estimate of $18.9 billion for Q4, that a forecast of $4.90 in EPS logically follows.

Gross Margin Estimates: 41.9%
Anyone can draw relatively reliable quarterly estimates for Apple simply by analyzing the seasonal trends of consumer spending of Apple products. Once one arrives at rigorously thought out revenue estimates, he or she must then perform an analysis of each line item of Apple’s income statement starting with gross margin.

Gross margin is the amount of money Apple makes on each of its products less the cost it takes to make those products. The only costs considered are the manufacturing cost, the bill of materials, and the packaging cost. These costs are called the cost of goods sold or ‘COGS.’ Subtracting the total cost of goods sold from Apple’s overall revenue will give you Apple’s gross margin.

Determining what Apple’s total gross margin will be in any one of Apple’s fiscal quarters requires an understanding of which of Apple’s product tend to carry higher gross margins, a careful analysis of Apple’s guidance for gross margin, the seasonal trend, the strength of the U.S. Dollar relative to the Euro, and whether a newly introduced product carries a higher or lower gross margin relative to the company’s average.

For example, in Q2 Apple reported 41.67% in overall gross margin percentage. The relevant information required to forecast gross margin for Q3 is: (1) Apple’s comments where it guides down gross margin to 36% owing to supposed lower margins on the iPad; (2) the seasonal trend which suggests that Q3 is stronger than Q2 for the past 4 years; (3) the amount by which Apple generally beats its own forecast (its sizable), (4) the number of iPhones Apple sells as the iPhone possesses the highest gross margin of Apple’s products, (5) the collapse of the Euro which suggests that Apple will see some pressure on ASPs this quarter (though Apple has admitted to be hedged for this potential event) and (6) the lower ASP on the iPod and Macintosh this quarter.

Based on an analysis of these issues (which I will publish in my earnings preview), I arrive at a 40.3% gross margin estimate for Q3. For while Q3 generally outperforms Q2, the weakness in the dollar, and the introduction of the iPad will undoubtedly put margin pressure on Apple this quarter.

Yet, when looking at Q4 gross margin estimates, one must consider the fact that Apple will likely sell well over 11 million iPhones due to the introduction of the iPhone 4. Knowing the iPhone to enjoy higher gross margins than Apple’s other products, one should conclude that overall gross margins will strongly benefit from huge iPhone sales in Q4.

Moreover, since the introduction of the iPhone, Apple’s best quarter for gross margins has been Q4. In Q4 2008, gross margin jumped from 36.28% in Q3 to 38.57% in Q4. In 2009, Apple saw a 1% increase from 40.92% to 41.82%. As Apple is set to record explosive iPhone 4 sales in Q4, I’m expecting gross margin to rise to 41.9% from the projected 40.3% I’m expecting in Q3. The chart below outlines Apple’s gross margin percentage from 2006 to 2010, which include my estimates for Q3 and Q4 2010.

Operating Expenses: $2 Billion
Based on the gross margin percentage estimate of 41.9%, I’m looking for Apple to post $7.922 billion in overall gross margin. To arrive at operating income, one must project operating expenses. Operating expenses are all the expenses related to running the Apple operation. The geniuses at the Apple store, Steve Jobs’ $1 income, the rental cost of all of Apple’s retail stores, the employees, the paperwork, the Apple campus in Cupertino and all other money spent to run the company are all what is included in operating expenses. Based on the current trend in Apple’s guidance, one can produce almost exact estimates for operating expenses.

There are several quarters where I was able to forecast these expenses almost perfectly because Apple would regularly guide $40 million under the actual results. Picking up on this trend, it has been relatively easy to predict these expenses. Yet, one must also consider the growth trend of these expenses to help facilitate a strong forecast.

For Q3, I arrived at an estimate of $1.850 billion in operating expenses based on Apple’s guidance, and based on the trend. Knowing that Q4 tends to be one of the highest quarters in terms of operating expenses due to Apple mass hiring to meet consumer demand of the iPhone and back to school shopping season, I’m expecting a $150 million bump to $2 billion in Q4. The chart below outlines Apple’s operating expenses from 2006 to 2010. Q3 and Q4 are merely estimates and actual results may vary.

Operating Income, OI&E and Income before Taxes
To arrive at operating income, income that Apple generates from its primary operations, one must simply subtract operating expenses from gross margin. Remember operating expenses are those expenses that only include the costs to run the entire Apple operation. Gross margin, on the other hand, is the amount of money Apple makes on the sale of each of its goods (revenue) minus the cost it takes to bring those goods into existence i.e. to make those goods. Thus, for Q4 I’m forecasting an operating income of $5.922 billion, which is the difference of subtracting $2 billion in operating expenses from $7.922 billion in projected gross margin.

Yet, companies will regularly make and/or lose money on the sale of property, from interest on their cash deposits, or from investments. Good accounting requires that we keep that income or loss in a separate category because it would be inappropriate to suggest that income from an investment should be part of the income that Apple receives from the sale of its goods.

So under generally accepted accounting principles (GAAP) we have a line item in the income statement called “Other Income & Expenses” or OI&E. Though the dollar amount of OI&E is generally a small amount compared to Apple’s operating income, it can and will regularly affect EPS and so it should be taken seriously. Based on Apple’s guidance, which generally undercuts or overstates OI&E by $5 million, I’m projecting OI&E to come in at about $50 million for Q3 and $35 million for Q4.

Finally, to arrive at income before a provision for income taxes, one only needs to add operating income to OI&E. In this case, I’m expecting $5.922 billion in operating income, and $35 million in OI&E for Q4. Thus, we arrive at a net income before taxes of $5.957 billion.

Provision for Income Taxes & Net Income
Income taxes can greatly influence the outcome in earnings per share, and thus demands careful consideration. Evidence suggests that Apple will post some very favorable tax rates for Q3 and Q4 of 2010. In Q2, Apple already posted an unusual low tax rate of 23.7%, and looks to continue that rate, based on its guidance, in Q3 and probably in Q4. Q4 is generally Apple’s most favorable tax rate quarter but only slightly better than Q3.

For Q3, I’m estimating a tax rate of 23.4% based on Apple’s comments for the quarter. I’m also expecting a very favorable rate of 23.0% in Q4. Thus, based on a tax rate of 23.0% for Q4, I’m looking for Apple to record a post tax profit of $4.587 billion in fiscal Q4. The chart below outlines Apple’s tax rate, inclusive of my Q3 and Q4 estimates, from 2006 through 2010.

Earnings Per Share
Once you arrive at net income, the job is basically done. One only needs to divide net income by the number of projected outstanding diluted shares to arrive at Earnings Per Share or EPS. Based on a projection of 935 million shares outstanding at the end of Q4 2010, my estimates are calling for Apple to report $4.90 in EPS on $18.906 billion in revenue versus the current consensus of $3.73 in EPS on a conservative $16.54 billion in revenue. The chart below outlines Apple’s EPS growth from 2006 to 2010. This chart presents undeniable evidence that Apple has entered yet another golden age of growth. Apple is truly firing on all cylinders.

Apple’s Earnings History
The four tables below present Apple’s revenue and earnings history from 2006 to 2010. Due diligence begs the average investor to have at least a general working knowledge of these tables. These income statements have been amended to account for Apple’s new GAAP accounting measures. These new accounting measures were implemented in Q1 2010 resulting in dramatic amendments to each of Apple’s fiscal quarters between 2007 and 2010. These income statements can also be found on Apple’s website.

Apple’s Year over Year Growth Rates
The three tables below outline Apple’s (AAPL) year-over-year growth rates for the past 3 fiscal years. The first thing that should be noticed is how Apple’s growth rate decelerated in 2009, and then reaccelerated in 2010. These tables are a very useful guide for performing fundamental analysis and establishing price targets on Apple. Also note the 75% net income growth and the 70.8% EPS growth in fiscal 2010. If this type of growth continues into 2011, then Apple will likely see $350 sometime next year.

Disclosure: At the time of this writing, the author holds no position in the equity markets. The information contained in this blog is not to be taken as either an investment or trading recommendation, and serious traders or investors should consult with their own professional financial advisors before acting on any thoughts expressed in this publication.

The End of the iPod Era Part II: The Other Side of the Debate

2010-07-05T22:20:00.000-07:00

I recently published an article arguing that the iPod’s importance to Apple’s overall quarterly revenue has diminished to the point of being almost irrelevant to Apple’s growth. Yet, this article seemed to hit the nerves of iPod aficionados who ardently contend that the iPhone is an iPod, and to say otherwise, would constitute the highest level of blasphemy to the Apple investment community. So I thought that in the interest of fairness and balanced reporting that I would present the other side of the debate, and let my readers decide which of these viewpoints makes the most sense.

In my previous article, I demonstrate how the facts according to Apple, suggests that the iPod is no longer that large of a revenue driver when compared to Apple’s other sources of revenue. I exhibit how the iPod as a percentage of Apple’s overall revenue has been on a consistent and steep decline since Q1 2006. This is due in part to the iPod’s maturing growth rate, and in large part, to the iPhone and Macintosh Computer taking the helm as Apple’s main source of revenue.

Apple’s fiscal year starts in October and ends in September. When it reports its quarterly earnings, Apple generally publishes a revenue breakdown for each of its six primary operations (iPhones, iPods, Macs, iTunes + music accessories, Software and Peripherals). It defines the general category of “iPod” to include sales from the iPod Touch, iPod Nano, iPod classic and iPod shuffle without reference to the iPhone.

So those four devices are what make up the revenue in Apple’s iPod category. While Apple doesn’t breakdown unit sales and revenue for each line of its iPods, Steve Jobs will from time to time let us know how many iPod touches it has sold during media events. Based on Apple’s definition of the term iPod revenue, the four charts below clearly and undeniably illustrate how the iPod as a percentage of Apple’s direct and recorded revenue has been on a steep and consistent decline since 2006.

If this isn’t already self-evident, here is exactly how the charts should be read. The first chart shows iPod revenue from 2006 to 2010. The second chart is of iPod unit sales. The third chart details iPod revenue as a PERCENTAGE of Apple’s overall revenue. This chart is important because it unmistakably illustrates how the iPod’s impact to Apple’s recorded revenue has been on a decline since 2006.

The fourth chart is of Apple’s recorded revenue from 2006 to 2010. This chart is important because it shows how Apple’s overall revenue has continued to demonstrate explosive growth despite the fact that iPod revenue (shown in chart #1) has posted either slightly positive or slightly negative growth over the past few years. Please note that Q3 and Q4 are merely estimates and that actual results may differ.

Misinterpreting the Analysis
My argument shouldn’t be construed, though I’m positive it will be, to suggest that I believe that Apple should somehow discontinue selling the iPod or that the iPod is doing poorly as a device. In fact, the iPod Touch is arguably one of Apple’s most important products as that device is a gateway drug to Apple’s other products, so to speak. It introduces those who don’t already own an iPhone to the iPhone OS making it the most proficient use of advertisement in the entire tech industry. That OS powers two of Apple’s most important product lines – the iPhone and iPad. And evidence suggests that this iPhone OS will power an all encompassing media hub being used in a flat screen TV that Apple is potentially developing.

Moreover, the iPod halo is still very much in full effect as each device gives consumers a broad introduction to the Apple ecosystem. So while the iPod isn’t as big of a player as is the iPhone or Macintosh when it comes to total revenue contribution, it still plays a key role in Apple’s overall business strategy. This much should be obvious as there still remains quite a large number of intangible benefits Apple derives from the iPod - a driver for revenue growth is just no longer one of those benefits.

One Alternative Viewpoint: iPhones are iPods, STUPID!
In January of 2007, Steve Jobs wowed his audience at Macworld, investors and the entire financial world with his introduction of the iPhone. During his keynote address, he called the iPhone “The best iPod Apple has ever made.” He began his introduction by saying, “Well today, we’re introducing THREE revolutionary new products. The first one is a widescreen iPod with touch controls, the second is a revolutionary new mobile phone and the third is a breakthrough internet communications device.” He continued, as the crowed held its breath, “An iPod, a phone, an internet mobile communicator. An iPod, a phone, an internet communicator…these are NOT three separate devices!” And to add a cheery on top, he went on to say: “we are calling it iPhone!”

This was huge news as the entire Apple world was convinced that due to legal constrains, Apple would be unable to name this new potential breakthrough device the “iPhone.” So it came as a great surprise to the entire financial community when he came out, gave the classic Steve Jobs’ finger to the term impossible (the reason everyone loves him), and called it the iPhone – I’m sure he told his lawyers to make it happen.

After reading the comments to my article published at Appleinsider, I discovered that quite a large number of people hold the view that the iPhone is an iPod. That even Steve Jobs made it perfectly clear that it’s an iPod (in fact the best iPod Apple has ever made), and that trying to characterize the iPod classic, iPod Touch, iPod Nano and iPod Shuffle as being Apple’s only iPods would patently misrepresent the facts. The “iPhone is an iPod, stupid” forms the basis of many of the arguments against the conclusion that the iPod (as defined in Apple’s financial statements) contributes an increasingly smaller portion of Apple’s overall revenue.

A lot would go on to argue that the only appropriate way to view and analyze iPod sales is by adding iPhone unit sales and revenue to iPod unit sales and revenue. Doing this, several have argued, will produce a true picture of the “real” iPod unit sales and revenue growth over the past 5 years. That the charts and tables outlining iPod sales above are inherently flawed because they unfairly breakdown iPod sales and revenue, as defined by Apple, without taking iPhone sales into account. The two charts below outline iPhone + iPod unit sales and iPhone + iPod revenue from 2006 to 2010. These charts form the basis of the iPhone is an iPod viewpoint. So without further ado, will the real iPod Category please stand up?

Thus, one will argue, that according to the two charts above, the “real” iPod unit sales, unlike iPod sales as defined by Apple and the rest of the financial world, shows that iPod unit sales are growing quite consistently. Sure, adding the two together dilutes the growth rate of iPhone standing alone; but who cares as long as we’ve shown that iPod sales are still growing right? “Real iPod” revenue growth is far more dramatic owing in large part to the $630 - $660 ASP that the iPhone normally enjoys versus the $150 to $170 ASP the iPod usually records. So while overall unit sales don’t look super impressive, revenue growth looks very strong. And we can’t get a true picture of how important the “real iPod” is to Apple’s revenue without looking at “real iPod” as a percentage of Apple’s revenue. The chart below outlines iPhone + iPod revenue i.e. “real iPod” revenue as a percentage of Apple’s overall revenue:

Notice how by Q4 2008, it appears that Apple gets about 50% of its business from the “Real iPod” making the company appear overly dependent on one of its primary operations for growth. While my argument shows that Apple is multi-dimensional and not overly dependent on the iPod, those in support of the iPhone is an iPod theory, makes it such that Apple is very dependent on this new category. Yet, the charts above do show how if the iPhone was characterized as an iPod, that iPod growth is alive and well. Of course it also demonstrates how important the iPod would become to the company’s financial well being.

Now here is why I think this is not only a very misguided, but dangerous viewpoint of the company from a financial perspective. First, the very last impression that any company wants to give investors, financial analysts and the financial media is that a company can only do a handful of things well, and that the company is too overly dependent on any one of its product lines.

In fact, Apple has worked very hard to demonstrate how well they are able to innovate by showing that they are not just a one or two dimensional company, but that they can make 4 separate and very successful products driving their overall revenue growth. By collapsing iPod and iPhone sales, it suggests that Apple is merely a two dimensional company. That the only thing they can do in terms of innovation is just make fancier iPods and sell Macintosh computers.

Apple has wisely chosen not to go this route. Instead, they break down their main revenue drivers into 4 distinct categories - iPods, iPhones, Macintosh Computers and now iPads. Over the past few years, iPod unit sales and revenue started to weaken. In the face of this weakness, Apple demonstrated their ability to innovate by introducing the iPhone and now the iPad. I’ve seen some arguments where some hold the view that iPads are merely iPods as well. This held belief is extremely counterproductive from a financial perspective.

Once again, no one is expecting that Apple or any company should be able to introduce a product that will grow from now into perpetuity. What money managers and analysts do expect is that Apple should able to make new fresh products that can take the helm of driving growth as some other product reaches maturity. In this case, Macintosh sales took over as Apple’s main revenue driver in 2007 followed by the iPhone in late 2008. The iPad will also drive future growth as the product sets to posts more revenue than the iPod in its inaugural quarter.

Fund managers are far more concerned with how well iPhone, iPad and Macintosh sales fare than they care about the archaic iPod. For the past few years, iPod sales have been slightly up to slightly down. Yet, no one seems to make a stink about it, because no institutional investor or analyst really gives a hoot about iPod sales anymore. Instead, the central focus of Apple’s financial picture is on the explosive growth the iPhone posted in Q1 and Q2 of this year.

What these two articles demonstrate is how Apple can innovate in the face of slower growth from its former main revenue driver, the iPod. These articles get ahead of future debates about whether Apple can continue to grow given the law of large numbers. Is Apple getting too big for its own good tends to be the general question posed among money managers and analysts these days. Not whether the iPod can continue to drive future growth. An argument that the iPhone is an iPod is definitely not the best way to view the company or its future growth prospects.

Instead, view the iPod for what it is. It’s a device that helped Apple escape the brink of bankruptcy. It’s a device that helped drive Apple’s growth for much of the past decade. It’s a device that produces quite a substantial halo effect for nearly everything Apple and introduces droves to the Apple ecosystem. The iPod Touch is very crucial in terms of introducing those who don’t own an iPhone to the iPhone OS. The iPhone OS has made its way in 3 separate devices, and evidence indicates that it will find itself in new and future products. The iPod is still very much important to Apple in these particular ways. But in terms of direct revenue, by the end of 2011, the iPod will barely make a dent in Apple’s overall revenue.

Another Alternative Viewpoint: Like Intel Chips, iPods are in All Apple Devices There’s another relatively strong argument put forth by a message board poster named Chano at Appleinsider. Chano contends that my article “misses the point” because iPods are embedded in several of Apple’s devices, and that this value should be counted in the analysis. Chano offers the following:

“Apple is selling more iPods today than all other products combined. Most of them are buried in the value proposition of the devices they are embedded in. I buy an iPhone because I want an iPod too. Without the iPod built in, how well would sales go? They still contribute to revenue. Embedded value is ADDED value. Intel’s chips are all embedded in something. They’re still counted in the sales value of the products they’re embedded in. It’s possible to break out a notional sales value for the embedded iPods as part of the selling price of the host device. It may be notional value but the embedded iPod is real. It should be counted.”

This is not a bad argument, and presents a stronger viewpoint than the iPhone is an iPod analysis. In fact, one can extract the added value of the iPod from each iPhone sale by simply subtracting iPod ASP from iPhone ASP, and add that value to iPod revenue. Basically, one could shift a portion of iPhone revenue and add it to overall iPod revenue. This would dramatically increase overall iPod revenue thereby indicating that iPod sales are in fact significantly stronger than my article suggests.

Yet, obviously one could counter-argue that it isn’t entirely obvious just how much added value the iPod actually contributes. That unlike Intel chips which are actually sold to a device manufacturer, actually used by every consumer of the device and make up a portion of the cost of goods sold, the iPod is simply embedded as an unquantifiable software feature that may or may not be used by the consumer of the iPhone.

In this sense, unlike Intel chips which are necessarily used by the consumer by virtue of using the device, the value proposition of the iPod depends largely on the varying needs of the consumer. My parents, for example, while they own iPhones, don’t use the iPod application. For them, the value is zero. For another person, that value might be $450 – higher than the iPod ASP. So in this sense, the quantifiable value in terms of a precise dollar amount is very arbitrary making the analysis upon which the value proposition is based, equally arbitrary. Thus, this viewpoint really has no value from a financial statement analysis perspective, but should be added as a sub-analytical argument suggesting that there’s an intangible benefit of the iPod to each of Apple’s portal devices (iPhones and iPads).

Secondly, while one could try to arbitrarily break out the added revenue value from those devices, it also would be very difficult to quantify this value in terms of unit sales. It would be a gross overestimation of iPod unit sales to suggest that each iPhone or iPad sold is an iPod sale as well. Because it isn’t entirely clear how many iPods would sell if Apple only introduced the iPod Touch. In other words, there are definitely a large number of people who buy the iPhone for features other than the iPod capability. Some may like the iPhone for the applications. Some might simply like the interface. Still, others might buy the iPhone for enterprise. Thus, it isn’t clear exactly how much value is added from a unit sales perspective.

So while this viewpoint is really more of a complimentary analysis that should be added to the overall iPod analysis, the fact still remains that total iPod revenue, as defined and recorded by Apple, continues to make up an increasingly smaller portion of Apple’s overall revenue.

Disclosure: At the time of this writing, the author holds no position in Apple. The information contained in this blog is not to be taken as either an investment or trading recommendation, and serious traders or investors should consult with their own professional financial advisors before acting on any thoughts expressed in this publication.

The End of the iPod Era: How the iPod has become Irrelevant to Apple's Growth

2010-07-02T09:58:00.000-07:00

A few years ago, I wrote an article detailing the iPod’s diminishing importance to Apple’s revenue growth. As Macintosh sales starting picking up steam, and as the advent of the iPhone assumed the helm of Apple’s future growth prospects, the iPod started a slow descent down from its throne as Apple’s key main revenue driver.

In January 2006, when Apple hit all time highs of $86.40, I remember how investors and financial analysts feared Apple’s best years were behind it. This fear, while apparently unfounded in retrospect, stemmed from the perceived belief that the iPod was near market saturation, and that Apple wouldn’t be able to innovate further. And though the market was in the midst of a raging bull market, investors saw Apple’s share price drop from $86.40 to $50.00 by that July.

Turn the page to 2010, the iPod is a mere afterthought and Apple has since seen its share price grow almost 6 fold. And while the iPod demonstrated a lot more resilience than anticipated by the financial world, posting record quarter after record quarter through 2008, its importance as a revenue driver has now diminished to the point of being almost irrelevant to Apple’s overall growth.

In Q1 2006, the iPod accounted for an astonishing 55.55% or more than half of Apple’s total revenue. For the 2010 holiday shopping season, though the iPod posted 250% more revenue than it did in 2006, it only accounted for 21.62% or just a fifth of Apple’s total revenue. That right there is a very tangible example of Apple’s ability to innovate in the face of an inevitable and impending slowdown of its main revenue driver, the iPod. The chart below details iPod revenue as a percentage of Apple’s total revenue from 2006 through 2010. Please note that Q3 and Q4 of 2010 are merely estimates based on a detail analysis I’ve published, and that actual results may vary.

Notice how the iPod’s impact to Apple’s total revenue has been on a consistent and continual downtrend since 2006. It is as if the importance of the iPod wanes by the day. In fact, I’m projecting that the iPod as a percentage of Apple’s overall revenue will fall under 10% for the first time in Q4 of this year. And to get an idea of just how significant that really is I’m expecting iTunes to account for 6.9% of total revenue in the same quarter. That’s an indication that the iPod is becoming just as insignificant of a revenue driver as is iTunes.

Yet, the chart above is even more impressive when one makes a side by side comparison to Apple’s total revenue in the same period. Even though the iPod has a diminishing an impact on Apple’s total sales from 2006 to the present, Apple’s revenue has outright exploded. In Q1 2006, Apple reported $5.75 billion in revenue of which 55% were iPod sales. In 2010, Apple reported $15.7 billion or almost triple what it reported in 2006. Yet iPod sales only accounted for a meager 21.6% of that revenue.

Any way you look at it, Apple is simply no longer dependent on the iPod, and any future signs of weakness should produce nothing more than a yawn. The chart below is a quarterly overview of Apple’s revenue from 2006 to 2010. Please be advised that Q3 and Q4 are merely projections, and that actual results may vary. A detailed look at how I arrived at those estimates can be found here.

Though the iPod is contributing less in terms of percentages, it still makes very hefty contributions in terms of revenue. In fact, while iPod revenue as a percentage of Apple’s overall revenue has been on a constant decline since 2006, the iPod has posted very consistent revenue throughout that period of time. The only thing that has changed is Apple’s product lineup, and an untouchable capacity to innovate. Hopefully this article puts the old adage, “As goes the iPod, so goes the Apple,” definitively the rest. Apple isn’t the just the iPod maker or the iPhone maker, it’s the maker of money. 2010 marks the end of the iPod era.

Disclosure: At the time of this writing, the author holds no position Apple. The information contained in this blog is not to be taken as either an investment or trading recommendation, and serious traders or investors should consult with their own professional financial advisors before acting on any thoughts expressed in this publication.

Andy Zaky's Guest Post on CNN Fortune

2010-07-01T14:23:00.001-07:00

Today CNN published an article I wrote on Apple's renewed volatility in light of this market sell-off. In this article, I track Apple's history in previous market corrections, and analyze the similarities and differences between how this and previous corrections have impacted Apple's stock price. I also comment on how I think Apple is likely to trade in the coming weeks in light of the broader market volatility. The article runs through some very key, and interesting analysis that many will find both pertinent and useful.

For a broader market analysis, I also submitted an article to Seeking Alpha today analyzing prospects of a double dip recession in light of the 8-month devastating head & shoulders currently unwinding on all of the major indices. You can find the broader market analysis here, and the Fortune article detailing Apple's renewed volatility here.

Head, Shoulders, Knees & Toes: A Warning Sign for Investors?

2010-06-30T09:09:00.000-07:00

UPDATE: For those who are interested, I've written a related article for Fortune that explores Apple's renewed volatility in light of the market's heavy selling pressure. You can find that article here.

While my readers know me best for my fundamental analysis and earnings forecasts, I will from time to time address overarching technical or fundamental issues in the broader market when I feel those problems can no longer be ignored. For example, in late April I mentioned to Philip Elmer-Dewitt (see here) that excessive unmitigated risk taking by fund managers as expressed by the ISEE index, the high call-to-put ratio on the CBOE, and the endless bid in the bond market would likely lead to a catastrophic sell-off in May. It was becoming increasingly clear that the European Sovereign debt crisis would eventually manifest itself in a brutal U.S. correction as the credit default swap market was nearly pricing in a default on Greece, Spain, Portugal, Italy and Ireland’s sovereign debt.

If this wasn’t evidence enough, the fact that the entire February to April rally was done on extremely light volume under the control of algos and high-frequency trading, should have raised quite the red flag. The market reached record over-bought conditions all while heavy mutual fund outflows continued in March and April. The S&P 500 set a new record for the number of days in the green without a sell-off of 1% or more during that rally. The 7-day Relative Strength Index hit levels not seen in 20 years on the S&P 500. This all suggested that the melt-up was more of a pump and dump routine than a real interest-driven rally.

Early in the correction, I followed up with Dewitt, and sent him the following e-mail just 7-minutes prior to the flash crash: “The markets are at very dangerous levels right now. If we don’t see a bounce here soon, we can see things really unravel. Warning bells are ringing everywhere right now on a technical basis. Volatility looks like it’s going to break out.”

The reason I was very concerned about the market minutes before the flash crash was largely due to the fact that I knew much of the market likely had stop loss orders sitting at the very key technical levels of 1140 to 1150 (January highs), and that due to the lack of hedging by the broader market, fund managers were more likely to put in stop losses instead of letting their Put protection, or lack thereof, kick in. If the market was sufficiently hedged ahead of this correction, there’s a good chance we wouldn’t have seen the flash crash. Because even if some of that selling was due to this so called “fat-finger” trade, at least 600 of that point loss on the DJIA was legitimate, orderly, stop-loss selling – I watched the orders go through.

Head & Shoulders Top
The warning I would like to discuss today is a technical problem I saw as potentially forming about a month ago. In an e-mail I sent to a group of day traders dated May 20, 2010, I noted that one of two very bearish technical formations would likely form if the market saw a rally to or near the January highs before testing 1,000 on the S&P 500. Because 1,042 marked the low of the late January to early February correction, a move exactly to this level on the S&P 500 would clearly form a neck-line of a potential 8-month head & shoulders top in the market. The other bearish technical pattern I saw as potentially forming in the market is something called an ascending broadening wedge, which is back-tested as being bearish 78% of the time. See here.

Yet, I think fears over a potential ascending broadening wedge forming is behind us, and now investors are confronted with a grueling head & shoulders top on all the major indices. The NASDAQ, S&P500 and DJIA have all formed a major head & shoulders not seen since the end of the 2003 to 2008 bull market (click links to see the charts). This chart formation is so concerning to me that I am now 100% in cash, and have been in cash for the past eight trading sessions. I believe this pattern can be potentially devastating to either bulls or bears as a strong case can be made on each side of the tape.

In 2007, we saw a strikingly similar head & shoulders form on the major indices which marked a decisive top to the 2003 to 2007 bull market. That head & shoulders spanned from March 2007, the first time the term “subprime” was discussed at any length in the media, until January 2008, where the neck line was decidedly broken in that major correction that ended with the collapse of Bear Stearns. Notice how the left shoulder of the 2007 head & shoulders was formed by a market correction on initial fears of the subprime mortgage crisis just as the left shoulder of the 2010 head & shoulders was formed by a correction on initial fears of the European sovereign debt crisis. Just as the markets initially brushed aside potential systemic risk surrounding subprime mortgages by rallying to all time highs on the DJIA (forming a head on the formation), the markets have initially brushed aside potential systemic risk of the European Sovereign debt crisis with a powerful melt up rally to form the head of this bearish formation.

A bear will argue that there are a lot of eerie similarities between how the market reacted from a technical standpoint when it was confronted with the subprime mortgage crisis, and how the market is currently reacting from a technical standpoint as it is confronted with the European Sovereign Debt crisis. In both markets, investors ignored initial systemic risk concerns by rallying to new highs only to revisit those concerns and form a neck line. It is precisely when the market gives credence to these systemic risk concerns do we see real weakness in the equity markets. Ben Bernanke gave the markets a strong dose of systemic risk reality when his comments during a White house meeting with President Barack Obama on Tuesday were construed to indicate that problems in Europe might spill over into the United States. Ben Bernanke remarked, “What’s happening around the world in emerging markets, in Europe affects us here in the United States, and it’s important for us to take that global perspective as we discuss the economy.”

Another head & shoulders top that manifested in a significant sell-off in the equity markets occurred this past April. The current market correction was, in fact, preceded by a clear head & shoulders top to the February-April melt-up rally (see here). The bears will point to these two very recent instances of this technical formation to conclude that we’re headed to at least 940 on the S&P 500. Major support in this market sits at 940 as that technical level not only marks the neck line of the bottom of the financial crisis, but it is also the 50% Fibonacci retracement level of the entire 666 to 1221 rally. Below the 940 level, the only support in the market is all the way down to the bear market lows of 666. Support for the NASDAQ sits at 1900, and for the DJIA, 8856 is the first line of support if the neck-line is in fact breached.

Finally, the bears will argue that significant weakness in the NASDAQ suggests that this sell-off is for real. It’s no secret tech stocks have lead this entire rally from the bear market lows to the April highs. Tuesday’s sell-off was lead primarily by weakness in tech, and more particularly, by weakness in the market’s biggest leader, Apple (AAPL). Throughout this entire correction, Apple has held up very well showing tremendous strength in the face of real weakness in the markets. Yet, Tuesday’s 4.5% sell-off suggests that the market is already beginning to shoot its leaders in the face, so to speak. When the market leaders go down that’s when investors should start to become concerned. As the NASDAQ is a weighted average, weakness in the stock had a sizable impact on Tuesday’s sell-off. While the DJIA and S&P 500 shed 3% of its value, Apple’s 4.5% sell-off lead the NASDAQ-100 (QQQQ) down 3.8%. Major weakness in Apple is highly suggestive that the market is headed for a sizable leg down.

Though a very strong bear case suggests the market is headed lower perhaps to test support at 940 on the S&P 500, a very solid bull case can be made for the opposite conclusion. Last June, the bears learned a very valuable lesson about putting too much trust into technicals in general, and the head & shoulders formation in particular. While the head & shoulders formation does generally tend to lead the market lower, there are instances where the market completely reverses course and goes directly into full blown rally mode.

Last June, the market developed a noticeable head & shoulders formation. It become rather popularized, and was discussed at length among traders, the media, on message boards and among fund managers. The neck line of that head & shoulders was even broken on a significant high-volume sell-off. Hedge funds and traders were very short the market at the time. All signs suggested the market was about to take a significant leg down.

Yet, the market completely reversed course and immediately went into a 60-day rally without so much as a pull back. I remember Art Cashin commenting on this reversal by saying, “the market will do what it can to make fools out of as many people as it can.” He went on to explain that because so many people were betting on this head & shoulders, that the slightest move up in the market lead to major short covering, which then turned into a sizable rally. It is last June’s reversal and Art Cashin’s comments that give me a great deal of reservation in remaining short the market right now.

However, a bear will argue that the current market is confronted with significantly different circumstances than the market in June 2009. For one, the June 2009 head & shoulders spanned only a number of weeks, which while bearish, isn’t quite as bearish as a head & shoulders top that forms over the span of 8 months. A bear will further argue that the fundamentals of the broader market in June 2009 are nowhere near as bearish as they are under the current environment. While I tend to agree with the bears in this case, I would rather stay in cash and look for buying opportunities if the market does in fact make its march down to 940 on the S&P 500. Instead of taking on the risk of a June-type reversal, I’m playing this next move on the market from the sidelines.

Disclosure: At the time of this writing, the author holds no position in the equity markets. The information contained in this blog is not to be taken as either an investment or trading recommendation, and serious traders or investors should consult with their own professional financial advisors before acting on any thoughts expressed in this publication.