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Trade of the Day: Take Another Bite From AAPL

Worried about AAPL's prospects after the Dec. 5 drop? Don't be.


Recommendation: Buy AAPL on a support bounce between $530-560 but under $600 per share.

Option alternative: Buy to open the out of the money June 2013 $560 Calls for $50 or less.

Apple (NASDAQ:AAPL) growth has been a perfect study of price-momentum. Even its pullbacks have been textbook-worthy examples of “technical corrections.” Like many growth stocks, AAPL has seen profit-taking since October. Some of that may have been triggered by the potential impact of the fiscal cliff but the selling looks mostly technical, which is good for investors considering a new entry opportunity.

We have recommended AAPL as an attractive long position before, in March 2012. The stock rallied 33% before topping out near $700 per share. The LEAPS option alternative that we recommended at the time gained in value by almost 400% before topping out in September.

AAPL is a classic value play. Its PE multiple is 25% less than the average among the S&P 500. AAPL’s return on equity (ROE) is 42.84%, which is #10 among the 200 largest technology companies on the exchanges. If we exclude stocks like AOL (NYSE:AOL) that have recently returned to profitability and have inflated ROE numbers, then AAPL ranks even higher. In dollar terms, AAPL is also one of the most actively traded stocks in the market — something we look for as technicians to make sure the market is efficient and easier to forecast.

But investors are understandably concerned about AAPL’s future, since it experienced its worst single-day drop on Dec. 5. So before making another recommendation, we need to be clear about why AAPL dropped in the first place, and why it should rise again.

Why Did AAPL Drop?

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The drop in AAPL’s price in the fourth quarter was in line with a normal technical decline as traders responded to a weaker market by taking profits. The stock formed a massive bearish divergence that would have predicted a decline to May’s lows (about 20%). A bearish divergence appears when bullish momentum is beginning to weaken and a bullish trend is likely to pause. A full 20% correction does not always occur, but considering the large gains in May-August it isn’t surprising.

Although the decline was hyped as the “death of AAPL bulls,” it’s only slightly larger (by percent) than the April and May declines. In both cases, the decline correlated with a broader market pull-back. At this point it is likely that value investors will become interested again and start driving the price back up before the earnings report in January.

 Fiscal Cliff Overreaction

If this was just a technical correction and the stock bounced at support in November, why did prices turn right back around and hit support again? Why didn’t the stock rally more in November if it is such a good deal at current prices? Our answer is that this has much more to do with investor behavior in response to the fiscal cliff as any inherent technical or fundamental weakness in the stock.

There was a lot of speculation that AAPL would join other cash-rich companies in offering a pre-fiscal cliff special dividend, and when it didn’t sellers emerged. This expectation seemed far-fetched to us over the last few weeks because most of the stocks that paid special dividends did so for the benefit of shareholders who want to take some value from the company before the tax change but don’t want to reduce their control. It seemed unlikely to us that AAPL would pay a special dividend after initiating a dividend program this year.  Therefore, the selling looks like an over-reaction.

General bearishness and dividend-expectation problems were occurring at the same time as margin rates increased for AAPL at the institutional level. That kind of change almost always affects the underlying asset – at least temporarily – and we would place much of the blame for the December 5th decline on that margin change. However, the change in margin requirements and the special dividend are not fundamental issues for the company.

Why AAPL Will Rise Again

The  fiscal cliff will come and go, and momentum always ebbs and flows, but we don’t see either of these issues having an impact on AAPL’s potential growth, sales, profitability and overall performance. It is true that projections for growth in the near term are slowing, which has been a problem for other high-flying stocks, but we don’t think it should be for AAPL.

AAPL has always had attractive fundamentals. Even at its highs, AAPL had lower valuation metrics on average than the rest of the S&P 500. AAPL is not like Netflix (NASDAQ:NFLX) or Chipotle Mexican Grill (NYSE:CMG), which both had PE multiples of 60 before their big declines. In fact, AAPL hasn’t had a PE multiple this low since it bottomed in January 2009, and just before it broke out of the consolidation in late 2011. AAPL has continued to look like a value stock rather than a growth stock all the way up, and that should provide plenty of protection on the way down.

What’s the Catch?

We stand by our analysis earlier this year that AAPL is still undervalued. Even if the firm returns to the average S&P 500 multiple of 16 the price should be over $700 per share.

But AAPL’s fluctuations since March of this year have produced the potential for a head and shoulders pattern.  So far the neckline at the current support level has remained unbroken. However, if we saw prices on AAPL cross below the neckline on firm volume, we would consider an exit. Head and shoulders patterns can become self-fulfilling prophecies and can take on bearish momentum regardless of the fundamentals. Buy the dip, but keep a tight leash on this trade until the stock gets back above $600 per share.

Recommendation: Buy AAPL on a bounce at support between $530-$560 but under $600 per share.

Options Alternative: Buy the June 2013 $560 Calls for $50 or less. This is nearly 10X leverage and should provide plenty of upside if the stock rallies as expected just before and after earnings in January 2013.

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