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On October 3rd of 2012, I suggested shorting Apple (NASDAQ:AAPL). Rather than basing this recommendation on product reviews or my subjective opinion, I relied exclusively on objective analysis. In this article, I will perform similar analysis and express my opinion that the bottom has yet to be reached in Apple's shares.

A History of Returns

In order to analyze any security, investors must cut through all opinion and subjective matter and focus exclusively on variables which can be quantified and tested. Through the testing of our ideas, we can know what actually drives security prices and be better informed investors. In order to quantitatively analyze Apple from a fundamental standpoint, I have relied heavily on return on assets. Return on assets is the net income of Apple divided by average total assets across an operating cycle. The benefit of relying on return on assets as an investment metric is that it allows analysts to normalize profits and compare them to the asset base required to generate those profits. In layman's terms, Apple's return on assets tells you how well Apple is doing its job of earning net income in light of how many assets it is required to hold on its books. The chart below shows 10 years of return on assets for Apple.

(click to enlarge)

The chart above shows two distinct economic periods in the history of Apple. In the points below, we will discuss these two periods. These two periods are summarized in the table beneath the discussion.

  1. The first period which we will discuss in this analysis is the strong fundamental performance from the beginning of 2003 until the second quarter of 2012. This period of time was marked by a surge in returns as Apple emerged from a losing quarter and entered into a decade of strong profits. Over this decade, Apple was able to penetrate nearly every market in which it decided to compete and profit margins rose in every single year to top out at around 30%. A fundamental rule exists within the financial markets and that is that as firms better themselves from a returns standpoint, investors tend to flock to the organization's shares. Apple is no exception to this rule and over the course of this decade, shares rose 8,028%.
  2. The second period which we will discuss is a period of declining economic performance. This period is from the second quarter of 2012 until the present. Over this time period, Apple has experienced declines in its performance, as measured by return on assets, in every single quarter. As has been demonstrated, the market rewards organizations with growing returns and punishes firms with declining returns. Apple is no exception to the rule of firm returns, and price has declined around 26% from this downturn.

In the table above, it can be seen that a clear and simple relationship exists between firm performance and stock performance. As a firm experiences growing returns, as measured by return on assets, stock price typically increases. Conversely, as a firm experiences declining returns, stock price tends to fall. It is on the basis of this simple and intuitive relationship, that I believe that the stage is set for further share price declines. I believe that investors should not purchase Apple's shares until it is able to reverse its fundamental decline, as measured by an increase in return on assets.

Statistical Analysis

When making an investment decision, it is typically unwise to rely exclusively on a single input. Through the examination of multiple investment methods, investors can better position themselves to understand and profit from market trends. In this section of the analysis, I will present a statistical method of study which hints at further price declines in Apple.

In order to statistically analyze Apple, I have relied heavily on a basic concept known as standard deviation. As you probably remember from high school statistics, when you take a standard deviation of a set of data, you can determine what the typical variance in a set of data is and objectively identify abnormalities. Applying this logic to the stock market, I have calculated standard deviation bands of weekly price changes of Apple. The chart below shows 5 years of this analysis.

(click to enlarge)

The chart above shows the weekly price changes for Apple surrounded by a 3-month standard deviation channel. Apple is an abnormal stock in that it has experienced dramatic price volatility over the past few years. Due to the abnormal nature of the security, investors can generate an investment thesis based upon statistical analysis. As you probably remember from high school statistics, when a figure arises in a dataset which is outside of a standard deviation threshold, the figure is considered to be a "tail" event, or an abnormality. The simplicity of this statistical rule allows us to generate and test a trading thesis within Apple. Since the security tends to abnormally trade, can we profit by shorting when price declines by a significant percentage? Conversely, will we earn profit by purchasing when price increases by an abnormally large percentage? I have tested the logic of this trading system and the table below shows the results from following this method for the past 5 years. The trade number corresponds to the point identified on the chart above.

It can clearly be seen that by trading abnormal price movements in Apple, profit can be generated. Over the past 5 years, this system has successfully called the ultimate direction of price the majority of the time. In fact, if investors would have relied exclusively on this method of trading, he or she could have earned a 142% return.

More relevant to our discussion however, is the current direction which this statistical system recommends. Statistically speaking, shares experienced abnormal downward price movements in the middle of November and prudent investors should have seriously considered selling or shorting to profit from the downside. The noteworthy takeaway from this statistical study is that price will more than likely continue declining until it has a large, abnormal movement to the upside. As discussed in our fundamental analysis, the economic landscape does not support price rising. For these reasons, I believe that the bottom has yet to be reached in Apple.

Oh, and by the way, historically Apple declines in 51% of all May periods. The odds just don't favor a long position in Apple at the moment.

Source: Apple: The Bottom Has Yet To Be Reached