Antonio Carradinha's  Instablog

Cisco and Mandelbrot

This article was conceived and written due to my immense admiration for a genius named Benoit Mandelbrot and one of his best books, "The Misbehavior of Markets - A Fractal View of Risk, Ruin and Reward", published in 2004. This book has been analyzed by another
author on Seeking Alpha.

For me, it is particularly challenging to conduct a review of a significant company such as Cisco Systems (CSCO) while taking into account Mandelbrot concepts.

Cisco is the worldwide leader in networking and other products related to the communication and information technology. Ups and downs of Cisco shares are naturally linked to the succession of its sales and profits over the years. This has to be compared with the expectations of investors and analysts. This interaction in conjunction with other market forces results in the formation of prices.

By Mandelbrot theory, what happened to the stock price of Cisco in 2000 was the bursting of a bubble. The variability of turbulent markets has two key features: a memory or long-term dependence and the risk of collapse. It is the pattern of exceeding the limit that caused the inevitable collapse. For a long time, Cisco investors have unreasonably increased the price of its shares sustaining overoptimistic expectations. When the quarterly results stabilized in 2000 investors lost their illusions and the bubble began to burst catastrophically. When the company recorded its first quarter loss in 2001, the bubble concluded its job and nothing could change it (a share's fall of 87% in 18 months). Not even decent results in the following years could make any difference.

Chart courtesy of StockCharts.com

(click to enlarge)

Cisco earnings and stock prices

From the tables below we can see the most relevant data from Cisco reports since 2007 to date.

Net income has continued to grow steadily, except in 2009 with the consequences of the global financial crisis and in 2011 with restructuring and other charges.

CSCO Net Income Quarterly YoY Growth data by YCharts

It is remarkable that net income has increased 44% in Q2 2013, thus making believe that Cisco will have a great year until the end of July.

How do these data have been influencing stock prices? As we can see in the chart above, there is a general correlation between net income and prices. Nevertheless, we can notice that advances in prices needed strong income growth while declines were easier to achieve as growth showed weakness.

John Chambers, Cisco chairman and chief executive officer said, "Cisco delivered record earnings per share this quarter and record revenue for the 8th quarter in a row in a challenging economic environment". "In terms of the future, we are making solid progress towards our goal of becoming the #1 IT company in the world" he added.

CSCO PE Ratio TTM data by YCharts

The market still "remembers" the exceptional burst of the 2000 Cisco bubble as it affected the stock performance over the years. In my opinion, the share's price is undervalued with a PER of 12.55 and a price book of 2.09. Not only in absolute terms but also in relation to other global technological companies, Cisco prices do not reflect company performance.

CSCO Price / Book Value data by YCharts

The memory will not disappear

Cisco share prices are still behaving as Mandelbrot stated in his theory of long memory. They show aversion in exceeding certain limits, down or up, preferring a safer way. Indeed, the long-term trading range from 2004 to 2013 has been maintained at a relatively wide scale but without showing any kind of persistent situation. In fact, it shows an anti-persistence standard. Even in recent weeks prices remained close to the average of the mentioned range without truly reflecting the last quarter excellent results and sound growth.

It is likely that Cisco shareholders have not forgotten the excesses committed in 2000. For that reason, it is quite clear why the stock price has never surpassed moderate levels. On one hand, this is good because prices can be considered solid. On the other hand, the company continues to gain ground in a dynamic and highly competitive market, which makes admissible an increase in prices in the medium term.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Take a look at the chart of Gold in euros to see that prices are below EMA50 and both of them are also below EMA200 which is now bearish for Gold. Never mind its price is dealt in USD because the problem is another sign of weakness. It must be emphasized that though all the fundamentals naturally remain we have to observe carefully the position of EMA50 and 200 in USD, as they are also very close of each other.

Chart courtesy of http://stockcharts.com
click chart to enlarge

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

We are all investors in the broad sense of the word although some prefer the short term and others medium or long term. In this analysis I am not considering the day traders or, in the opposite camp, the very long term investors - Warren Buffett style, though they are respectable ways of being in the market, especially the last one that naturally made a vast number of followers.

But almost all of us like to do trading and this action is often appropriate and necessary to take advantage of the volatility of a security, buying or selling in trend reversals, whether of small or large duration.

To properly frame trading of a given security we should observe the following:

1. Reference value of the action in accordance with current data and future guidance
2. Security Trend
3. Market Trend
4. Use of appropriate technical indicators

The shares of Facebook (FB) are currently very much desirable to trading as we are yet on the after IPO period. Actually we see increasing unlock of their shares, which are arriving in waves to the market and relevant volatility of its prices.

Although, personally, I think FB can provide in the future a long-term investment, currently trading is definitely the action to undertake. Following the above, we must consider as price reference a range between 25 and 38, for the following reasons:

1. The price of IPO was 38 and that value sooner or later will be achieved again, not only for the volatility but also because FB is growing with substantial profits. When that happens, it will be a strong resistance level, and if broken is also very important for trading.

2. For months, the company has been in sell-off and 25 zone was an important support level which has only been broken down after serious attempts. When, later, rose and broke up the same barrier did so with extreme difficulty making that level of the utmost importance if a subsequent and pronounced decline happens.

3. In fundamental terms, the value of each share of FB can perfectly fit within that wide range, depending on what is considered the degree of growth of its earnings, free cash flows and the discount rate chosen. If we could be more optimistic about its value, FB prices could even quote higher especially if the market is bullish.

Now I present a chart of FB since it entered the market until last Friday (11.January.2013), where I introduced some technical indicators chosen and adapted to FB and better suited for the time it has been negotiating. Any buy or sell signals will only be considered when all three indicators confirm it.

I considered the Stochastic Oscillator, a price velocity indicator, with 16 periods (k=16, without signal line) generating buy or sell signals depending on the rise over 50% or the fall down 50%.

Also used the Money Flow Index (which combines momentum and volume) only as an indicator of bullish or bear bias using also the centerline 50.

Percentage Pice Oscillator is the last indicator chosen as a momentum oscillator. PPO is positive when the shorter moving average is above the longer moving average and negative when the shorter moving average is below the longer moving average.

(click to enlarge)

^{Chart courtesy of StockCharts.com at http://stockcharts.com.}

We can observe that the chosen indicators gave the following signals in accordance:

a) Sell signal (or short position) in early July;

b) Buy signal in early September;

c) Sell signal in early October;

d) Buy signal in late October, without a sell signal in November because the Money Flow Index did not allow.

e) As until now those three indicators together gave only confirmation signals, the long position remains in good shape (the sell signal given by PPO in early December and the confirmation given by Stochastic was not followed by Money Flow Index, which could stay very close to 50% without really breaking).

After November is also significant that FB price has been always above EMA50.

Don´t forget that, in trading, you must map the performance of chosen technical indicators against your specific stock and stick to your strategy. If you are not sure of your chosen system, change to one you feel more comfortable with and do an appropriate back test.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.