Drug manufacturer Cephalon (CEPH) looks like a classic case of an over-loved stock that just hasn’t produced.
In fact, looking at CEPH’s chart, it’s hard to understand why anyone would embrace this stock. That’s OK by us, though. We love situations in which the chart and sentiment are in totally different camps, especially heading into a company’s earnings report.
Let’s start with the chart.
CEPH has trailed the broader market badly for the past eight months, and is now trading around the July lows. Other than the summer bottom, there isn’t anything keeping the shares afloat from a technical perspective. No daily, weekly or monthly moving average sits within shouting distance underneath the current share price. Pretty ugly.
Despite CEPH’s struggles, sentiment remains remarkably positive. Keep in mind that optimism represents higher expectations and, thus, can create some vulnerability if those expectations aren’t met. (Conversely, pessimistic sentiment reflects lower expectations that often lead to upside earnings surprises.)
The put/call ratio has been trolling around an annual low for the past two months, even though the stock has been technically weak. Heavy call open interest at the $55 and $60 strikes should help keep the shares in check.
Analysts are similarly optimistic, although the tide may be shifting. Currently, 17 of 27 covering brokerages rate the stock a “buy,” while the remaining 10 are “holds.” But this configuration is more bearish than it was three months ago.
Just two weeks ago, Cephalon was downgraded by an analyst who felt the company would have difficulty meeting earnings expectations. He also cut his 2009 and 2010 profit estimates based on weakening sales of some of the company’s flagship drugs. That’s not encouraging.
Cephalon reports on Oct. 27, with analysts expecting a 20% increase in profits from a year ago. The company has beaten expectations for three straight quarters, but has performed poorly following each report, dropping an average of nearly 9% in the two weeks following the earnings release. That’s a disturbing trend — if you’re a CEPH bull (which we are clearly not).
As of now, CEPH looks like a textbook bearish case of lousy technicals, questionable fundamentals, and misplaced optimism that is showing signs of unwinding.
We’ll see how the stock behaves at current levels before deciding to buy put options. A drop below the July lows would provide a great entry point for a bearish trade.
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