Was Google's Price Decline Predictable?

Jan.20.12 | About: Alphabet Inc. (GOOG)

Could we have predicted the decline in Google’s stock today? We think so. Let’s just quickly review the earnings.

First, the good.

  • Revenue was up 25% year over year
  • paid clicks were up 34% year over year
  • traffic acquisition costs were 24% of advertising revenue versus 25% last year
  • free cash flow was almost $3 billion for the quarter
  • they have 90 million Google Plus users
  • over 700,000 Android activations per day

Now, the not so good.

  • Earnings missed estimates by .95 cents
  • cost per click (CPC) fell by 8%
  • international revenue fell as a percentage of sales
  • ‘other’ costs including incentive compensation rose significantly

No doubt there are other details that are important, but after reviewing the above highlights, does this seem like a stock that should be down ~8%? It does not, in my opinion, so why the violent reaction?

The alternate answer was simply that investors went into this earnings report in too bullish of a position. They did not have any protection in place in the event of a disappointment. Case in point, we built a model that shows the option action of Google over the past 12 months. We matched the stock price of Google (black line) versus a weighted combination of the call-put volume (75% weighting) and the call-put open interest (25% weighting). We chose this breakdown in the belief that short-term volume holds more importance, so consequently should be weighted higher. Additionally, we changed this custom data series into a 10 day (blue line) and 50 day (red line) simple moving average to smooth out the gyrations.

Google Option ModelClick to enlarge

Further, the color coded oscillator represents the differential between the 10 day (blue line) and 50 day (red line) moving averages. Different colors are shown for the number of standard deviations they are away from trend. What does this show? It shows that over the past week or so the 10 day moving average was over 3 standard deviations above the 50 day moving average line. In other words, call buying and ownership on a short-term basis had risen too far, too fast and this left the stock vulnerable to a disappointment.

Yes, we could have predicted Google’s price decline prior to their earnings, if only we would have reviewed it prior to the release ourselves..

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.