Finding a Profitable Pattern

I have noticed a profitable pattern. I am going to cast this from the bearish perspective, but in theory it could work either way. I have a few other historical examples, but let us focus on the present.

Background

Investors have many time frames, and so do those managing money. When you see someone interviewed on CNBC it could be a mutual fund manager, a hedge fund manager, or a trader. It is natural for everyone to talk his book, but the time frame is relevant.

A mutual fund manager likes to see holding increase, get publicity, and attract new assets. Having said this, these managers are not likely to sell into rallies. Instead, new money in their funds gets invested at current prices in current holdings.

A hedge fund manager or trader is different. Their disclosures warn that they may change opinions and trades in a heartbeat. They can, and should, do so. A five percent move in a stock is a major trading profit.

The Process

A portion of the hedge fund community takes a position. For this example, it is a short on semiconductor stocks. The position is supported with plenty of reasoning they deem to be rigorous and also by technical analysis. It is especially desirable to find a situation where a sector has made a big run. A chart of the SOX tells the story (click to enlarge)

I haven't added any lines in this, and readers should ignore the last decline, since that is the end of the story. The point is that analysts could have a field day with this chart -- before the decline.

Cocking the Hammer

Those establishing a bearish position wish to highlight major concerns. In this case the "hammer" was the question of double booking of orders. This occurs when inventories are so low that those building mother boards want to be assured of needed parts. To do this, the theory holds, they place multiple orders for needed parts in short supply, canceling some orders when their needs are met.

It is an argument that raises a question about the validity of reported orders, and creates fear that the orders will decline.

Pulling the Trigger

One might think that actual evidence of order decline would be necessary to trigger the fear. That assumption is incorrect. It is easy to grasp any news as evidence that this prophecy has been fulfilled.

Thursday, the B of A/Merrill analyst downgraded the entire sector. The resulting report, which I have read carefully, is based upon an inventory model and some assumptions about where we are in the cycle. It does not specifically refer to any double booking, and the resulting forecasts are still above many other Street observers. It was a big call, getting a lot of play, and knocking down the stocks by 5 percent or so, as the chart indicates.

Bearish observers incorrectly cited the double booking argument, not actually mentioned in the report. It talks about a small "overshoot" in inventories, not mentioning any double booking. It is based upon a theoretical model, without a lot of supporting evidence. Since few actually read these reports, the inaccurate summaries gain credence.

The Result

Anyone with a short position can cover for a nice trade. It was a nice setup. Any downgrade could be cited as evidence. When the analyst from a big firm downgrades, everyone pays respect, at least in the short term. That is long enough for traders and hedge fund types.

The Facts

There is plenty of evidence contradicting the double-counting argument:

From iSupplyCorp we have the following:

In their earnings announcements, leading semiconductor suppliers, including Texas Instruments, STMicroelectronics and Intersil, all reported they saw no signs of double-booking during the third quarter, said Ciriello. “This should give the semiconductor industry confidence that the magnitude of the current recovery accurately reflects real demand levels.”

A balanced article at the WSJ mentions the double-booking issue:

Another analyst, FBR Capital's Craig Berger, also cited signs of weakening PC demand, though he said in a note, "We do not want to get overly bearish on the PC space given improving global demand and still-unknown holiday sell-through trends."

Berger said he remains "bullish" on the semiconductor sector. "We think fears of a first half of 2010 estimate cuts from double ordering are overblown, that global supply chain inventories are at or near all-time lows, that global demand trends will continue to recover in 2010."

Astute tech stock observer Bob Faulkner writes as follows (see the full article for his nice inventory charts and complete analysis):

I've tracked inventory in the electronics-supply chain for years. While it’s too early in earnings season to draw any final conclusions, I think it’s very safe to say that inventory is quite tight on a relative basis.

Steve Ballmer reports that Microsoft (MSFT) sees "fantastic sales" for Windows 7. If this is accurate, it should stimulate a new cycle of purchases. More people and businesses replace computers -- especially those who avoided VISTA -- than upgrade existing machines. The current hardware may not be adequate and is difficult to configure.

Our Take

The trading setup is a real dilemma for managers with a long-run horizon. It was completely predictable that something -- anything -- would be seized upon as confirmation for the double-booking argument. There was no need to wait for actual evidence. Even knowing this, should the manager blow out all of his chip holdings, expecting a pull back of unknown size?

The real answer for those with a longer perspective is to focus on the actual time frame and ignore the bumps in the road. The traders will make their profits, and eventually the results will tell the story. It is an opportunity to add to positions for those who disagree with the thesis.

An Interesting Exercise

There was a similar setup -- hammer pulled back -- on car sales after the Cash for Clunkers expired. Perhaps this is a good topic for an example where we now have more evidence -- an immediate decline, followed by a restoration in sales.

I invite other examples -- both long and short -- from readers. Look for the setup -- what we all should watch for-- and then look for evidence.

Our position: Long INTC, MSFT, and AAPL.

Comments

[David White]

Interesting thesis. There may be some merit to it in the semiconductor space. Certainly John Chambers of Cisco has come out as a recovery touter. This might indicate other businesses are seeing the same situation. If so, your thesis may play out. However, you mention being long AAPL. This is one area I would tend to disagree at the moment. There is increasing competition in the IPhone and IPod spaces. Apple does not seem to be leading so much anymore as creating me-too products. Windows 7 may actually make the PC competitive with the MAC, which is also probably more expensive. The IPod has many competitors. The IPhone has many also. More importantly, it now has the Android, which is open source, as a competitor. It seems likely to lose market share longer term. Google/Motorola is a formidable opponent. The Apple E-Reader product will be one of many. All this should hurt Apple sales and margins going forward. If there is some new great product, I haven't heard of it yet. Apple will not disappear overnight. I am not saying they will lose money. I am not even saying they will lose sales. I just think that the kind of growth we have been seeing will likely not be there. When Apple only meets expectations in coming quarters (or god forbid misses expectations), the stock price will falter.

Longer term Apple may come up with new ideas. It may find new ways to differentiate itself. Or it may settle into a comfortatble mediocrity that ultimately ends in it losing business. It has done this before. Is that cycle about to repeat?

2009 Nov 22 03:07 AM

[Marco G.]

Jeff, I find your article very informative, thank you.

2009 Nov 22 08:30 AM

[Scootger]

great thesis, i like the way you see the difference between the mutual fund and hedge fund investor...i get the sense that everyone has taken their foot off the gas in semi's the last few weeks, but i would not bet on a serious correction in the space. semi's are acting better now than they have in 5 years and APPL and MSFT are putting a floor in them to a certain extent, i also expect to see more consolidation in tech and semi that will drive the space higher on any given day(a little extra umph')....i would look for names that are beaten up in the space that you can scoop up on the cheap relative to its peers as a way to get long...Example - AMAT-recent "weak" q followed by downgrades(anaylsyts helping pounding it down),
I am long on this move and so are hedge funds, this is how they, enter on weakness not strength.... Happy Trading:)

2009 Nov 22 09:39 AM

[Old Trader]

Jeff,

Another good article. The mention of time frames is certainly appropriate and telling. Which is why, when I'm considering "putting on a trade" (as opposed to iniating a long term position), I check both the daily, as well as the weekly chart of a stock.

David Wrixom,

Jim Jubak, over on MSN Money, had a good piece on Apple, and what's going on in the tech space about a week, or so ago. You might find it an interesting read, if you haven't seen it yet.

2009 Nov 22 10:08 AM

[Old Trader]

David White,

My mistake...should have been "speaking" to you, not David Wrixom.

2009 Nov 22 02:41 PM