Throughout the past few years, Apple (AAPL) has been a shining security throughout the United States economy and the stock market. Many have hailed its ascension to power as a reinvention and reorientation of the economy and investors. Over the past 4 years, the stock has added over $400 billion in shareholder value and many investors believe that the security is nowhere near topping out. Through this analysis, I present the case that Apple is an overbought security and recent fundamental, statistical, and technical breakdown suggest that the top may be in the process of forming and further downside is possible.
A History of Returns
I begin this study by analyzing Apple from a fundamental standpoint. In order to properly analyze the company's performance, I have relied heavily on return on assets and return on equity. Return on assets is the net income of the firm divided by average total assets and this ratio informs the investor how well Apple uses its assets to generate profits. Return on equity is the profit of the firm divided by directly-invested shareholder equity and this ratio informs the reader as to how efficiently management utilizes investments to generate income for the firm. These two ratios provide a comprehensive picture of firm performance and can aid the investor in the timing of his investments.
The chart above shows 5 years of history for return on assets and return on equity. The investor should immediately notice that these ratios have been in a steady uptrend since the beginning of the chart. Indeed, Apple has performed very well over the past 5 years and from a fundamental standpoint, it deserves the market value that has been added. In traditional finance, as a firm generates profits and grows returns, its stock price should respond by increasing. This has been true in that during the time period studied, Apple's stock price has risen over 500%. The recent quarter however, gives rise for concern. In the second quarter of 2012, return on assets and return on equity suffered yet the stock price continued to rise. In fact, while return on assets and return on equity decreased by several percentage points, stock price has increased around 6%. This represents a decoupling between fundamental performance and stock price performance. As the firm has experience an erosion of performance, the market has rallied. I believe that this recent run-up in prices can represent a shorting opportunity for the patient and prudent investor.
It is important to note that the current level of return on assets and return on equity are excellent. By all means, Apple is performing very well from a fundamental standpoint. But it is essential to understand that organizational returns and stock returns should be, but are not always related. As the organization increases its performance, stock price should rise. When performance falls, stock price should decline as well. This has been the case with Apple over the past quarter - stock price has increased while fundamental performance has decreased. From a fundamental standpoint, if Apple is able to reverse its current return levels and overcome the recently-established peak, then investors should temporarily shelf shorting ideas until performance once again begins to decline.
It is my belief that Apple's decline in return on assets and equity will continue. I base this belief on the fact that Apple has experienced the largest reduction in returns in the past quarter than it has in the past 5 years. This represents a pullback in the fundamental condition of the organization. Individuals may argue that an in-depth study of the newest products, such as the iPhone 5, is more relevant than history, but this viewpoint ignores the historic facts of the organization. Apple has been developing groundbreaking products for years. The glamour and speculation surrounding the company has be prevalent throughout history and continues to be prevalent. For an investor wishing to skip the speculative fervor and instead focus on bottom line performance, I believe that the information found on the financial statements fully encapsulates the heart of the organization. For this reason, I believe that the recent pullback in fundamental performance coupled with an increase in stock price represents a solid investment catalyst.
Another method of analyzing a security is through statistical analysis. By utilizing statistics and historical distributions, we can gain insight into what is "normal" and potentially profit from a decoupling, or shifting in normality. The historical statistical distribution of Apple can be seen below.
What the chart above shows across the horizontal axis is weekly returns through time. The upper and lower bands surrounding these returns are two quarterly standard deviations of the data. A basic interpretation of the data is that when a return is above or below the bands, an abnormal price move is present. Additionally, when the bands are widening, volatility is increasing; and when the bands are narrowing, volatility is decreasing. The layman's definition of volatility is uncertainty: when the bands are widening, the market is more uncertain about price direction and the opposite is true for a narrowing.
Between the months of February and April volatility was decreasing and share price was increasing. This period of time essentially meant that the market was certain that the statistically-sound direction was upwards and the stock price increased over 30% during these months. Between April and June however, uncertainty increased in the market and share price lacked a clear direction. The market became progressively more certain of its direction between June and August, and share price increased nearly 15%. In the month of September however, something very noteworthy occurred: price began declining and the market confirmed the results through low volatility. During the month of September, prices decreased nearly 2% and the market was certain that this was the statistically normal course of action. Essentially, this means that from a statistical standpoint, further downside in price can be entirely expected and a new downward trend can potentially emerge.
I have established that from a fundamental and statistical standpoint, a pullback in share price may be warranted. An additional telling bearish factor for Apple can be found through technical analysis. Technical analysis is essentially the study of historic prices in the attempt to forecast future prices. A primary pattern that technical analysts rely on is something known as the "head and shoulders" pattern. This pattern typically calls market tops and a study of history will show that it can be found at the beginning of the majority of bear markets. The chart below shows the technical landscape of Apple.
The price action in Apple is a textbook head and shoulders pattern in formation. In the first quarter of this year, price rallied strongly and this rally was coupled by an increase in volume. Between April and July, prices declined before beginning an additional rally which lasted through September. Just as the initial fathers of technical analysis noted that the "head" of the head and shoulders pattern is typically formed with decreasing volume, Apple has recently formed a peak on lower volume. This essentially means that the recent run-up in price was not accompanied by large interest in the security. According to technical analysis, this is the highest that prices will travel before entering a bear market, if this is a true head and shoulders pattern. The final factor that will denote that Apple has truly topped out will be a break of the "neckline" at $520 per share. If price is able to fall below this line, then a short trade should be initiated. For now, the intelligent investor should be monitoring the developments within the chart in preparation for further price decline. If this is a true head and shoulders pattern, then a final shoulder should form over the next few months and a break below the $520 point will signal a decline in share price.
It is important to note that this price target represents a 20% decline in market prices from today's values. This may seem like a large decline and investors may think that this is not such an important and pressing event, however Apple can move very quickly. For example, between the beginning of August and mid-September, price moved over 20% - and this movement was without significant fundamental development in the form of financial statements! Ironically, this uptrend was preceded by guidance in which Apple admitted that it would performance less than expectations - further casting suspect on the recent rally. I believe that investors in Apple should be alert that the current volatility of Apple is such that this head-and-shoulders pattern could complete in a matter of weeks and should prepare accordingly.