Apple: Sell Into Strength

Apple (AAPL) has seen its share price run up considerably in recent months, but could soon experience a pullback due to both fundamental and technical reasons. The overall trend higher remains intact for Apple, but investors should still be aware of potential headwinds and how to position for it. On a long-term chart, Apple looks overbought to a level that traditionally has seen selling pressure in the months after. Moreover, relative to the broader S&P 500, Apple is hitting relative resistance levels.

Although Apple’s price to earnings ratio is still very reasonable, its current level has been an area where investors have taken profits in the past. Finally, with its upcoming product release, shareholders could play the buy the rumor, sell the news game, also leading to selling. Apple remains a long-term buy, but selling pressure for a number of reasons could be on the horizon, which gives rise to an interesting options strategy to hedge out your position.

Price Action

The first chart of interest is Apple on a monthly timeframe, going back to early 2005. Over the last decade, Apple’s trend has been significantly higher, with various pullbacks along the way. The pullbacks have not done structural damage to Apple’s uptrend, and for the trend followers out there, Apple continues to show long-term strength until the trend is violated.

Something to take into consideration however is that when Apple’s price action is very strong, leading it to run well above its 10-. 20-, and 40- month moving averages, a reversion to the mean usually follows in the months after.

Of course, there are periods where Apple trades well above its long-term monthly averages for many months, or years, but this current period comes alongside a number of other warning indicators.

Relative Price Action

Apple has pulled back following periods of outperformance relative to the S&P 500 since the financial crisis. The chart below is a ratio of Apple’s price to the S&P 500 index. In 2012, 2015, and now in late 2017, Apple’s price has tended to sell off following outperformance, which led the tech giant to reach highs of a 0.065 ratio to the index.

You can think of this as price outperformance becoming stretched, and thus reverting back lower to the average. The 0.065 may not hold, and Apple could break out higher, which in itself would be a significant signal, but based on the recent past, investors have taken gains as Apple runs higher to current relative levels.

Valuation Multiple

Similar to the chart above, investors have tended to take profits over the last decade as Apple approached an 18-trailing, 12-month price to earnings ratio. Although the valuation multiple is still considered undervalued to the broader market by most, investors have generally chosen taken profits at these levels.

The range is fairly significant, with investors having scooped up the tech giant around a 10 PE, while choosing to sell as the valuation multiple approached 18. This trend looks to be continuing as selling pressure has started to build at a PE near 18 currently.

Fundamental Narrative

While the company remains fundamentally well positioned for the long-run there are a number of headwinds that could lead to selling pressure into the end of the year. Issues with shipment delays of its iPhone X have created shortages, which could weigh on guidance when the company reports quarterly results on November 2. According to Gizmodo:

“There have been rumors that the company is having difficulty producing the 3D sensors that power facial recognition in the highly anticipated iPhone X is leading to manufacturing delays. This could ultimately lead to shortages when pre-orders for the device open on October 27th.”

Additionally, there have been negative comments regarding the iPhone 8 due to the incremental nature of its upgrades, while the iPhone X is pricey, with customers potentially delaying purchases in anticipation of upgrades next year, ultimately weighing on shipment performance later in FY18.

Guidance will be key for Apple during its conference call, but again, any hesitation regarding iPhone X demand further out into 2018 could drive its share price lower. Considering the quantity of overbought readings on the indicators listed above, investors have shown the propensity to sell at these levels should expectations begin to wane.

The Trade

Long-term investors unconcerned about 5%-10% corrections should stick to the game plan and continue to hold shares. For more opportunistic investors, you can trim your longs, and add more on a pullback, or even go as far as to initiate a put spread to make money on a potential down move over the next few months, while also leaving unlimited upside potential.

The spread I’m looking at is the June 2018 155/145 bear put spread, costing $ 4.20 to make $ 5.80, or a 138% return on capital. The position is a play on a minor pullback to its major trend line. Remember that it is possible to lose all of your premium in the options strategy, and thus the position must be weighted appropriately.

Conclusion

Apple remains in a strong uptrend, but a number of factors are shaping up that signal a potential drawdown lower. Price action is overbought on long-term charts with relative price action to the S&P 500 also looking stretched. Moreover, Apple currently trades at a PE level that traditionally has served as resistance, leading investors to take profits in recent years. Finally, there are a number of fundamental factors that could weigh on the stock in coming months. For buy and hold investors, this isn’t something to be too concerned about, but more tactical investors can potentially gain from a 5%-10% correction lower, as Apple reverts toward its major trend lines.

Disclosure: I am/we are short AAPL.

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.

Additional disclosure: Put Spread

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