Event Trading: Empathy & Market Saturation

By: Chris Verhaegh

The following is an excerpt from Chris Verhaegh's The PULSE System

Empathy

This is an interesting phenomenon.  Many times we’ll see a news announcement pertaining to one particular company and the stock will move dramatically.  It could be bad news, like a lawsuit or a scandal.  Or on the positive side, it could be an Earnings report.  When that happens, many times we’ll see other stocks in the same industry move in empathy with that stock!  The moves for the other companies won’t be as dramatic, but they will be in the same direction.

Precious metals are an excellent example of this.  There are several stocks, indexes and ETFs related to precious metals.  When one moves, the others are likely to follow shortly after.  Especially with Gold and Silver.  They’re like Siamese twins.  When one goes, the other will too.

FAS and FAZ is a great pair to pay attention to if you’re looking for empathy moves.  These are 3X multiplier ETFs of the banking sector.  FAS is a Bull multiplier and FAX is a Bear multiplier.  FAS rises when the banking sector rises (Bullish).  FAZ rises when the banking sector falls (Bearish).  We like trading FAS and FAZ for a couple of different reasons.  First, they can never go to zero.  Well, theoretically, they could, but if the entire banking industry drops to zero, we’ve got bigger problems than figuring out which options to be trading!  Secondly, since they are ETFs, they have no Earnings releases of their own, but they both react to the Earnings releases of banking stocks like JP Morgan (JPM), Bank of America (BAC), or Wells Fargo (WFC).

When a large banking company has an Earnings release, the options for that stock are going to be expensive.  The options on FAS and FAZ will not be priced with the same Expected Volatility, but will move in empathy with the banking stock.  That’s where we cash in!

Market Saturation

Some events aren’t quite as obvious to the novice trader.  One of those not-so-obvious events is Market Saturation.  Stock growth doesn’t just happen because a company is performing well.  There are many factors that affect stock growth.  One of those factors is Market Saturation.  Actually, I have a name for my personal Market Saturation indicator.  I call it the “Nowhere else to grow – Boise Idaho” Indicator.  My theory is - if a company has grown to the point that they’re opening stores in my hometown of Boise, there’s nowhere left to go!

About a decade ago, the Wall Street darling at the time was Krispy Kreme Doughnuts (KKD).  Since there weren’t any Krispy Kreme outlets in Idaho, people would have to travel over four hours to the northern suburbs of Salt Lake City, Utah to get their doughnut fix.

At the time, KKD had a program in effect where they would sell doughnuts by the case in specially marked boxes (holding a dozen doughnuts each) to charities for a slight discount to normal retail pricing.  After an eight to nine hour trip, these doughnuts were sold on street corners around town.

Every weekend throughout the Boise area, you would see the adult version of lemonade stands – but instead of sugary slurry in a cup, it would be these famous sugary glazed doughnuts.  When Krispy Kreme announced they were opening a baker just west of Boise, it was front page news.  It was the opening story on the evening TV news broadcast on all channels.

True story; someone pitched a tent in the parking lot for three days so they could be the first person to buy “Fresh Hot” doughnuts.  The only thing hotter than these doughnuts was its stock price.  That is, until you could buy them in Boise, Idaho.

I remember Krispy Kreme’s fundamentals in 2002.  There were 295 outlets selling doughnuts (not counting street corner or gas station sales).  The company had a $2.95 Billion Market Cap; meaning all the shares in existence multiplied by the share price valued the company at almost $3 Billion Dollars.

The Fundamental Analysis on KKD said its share price was valuing each outlet at an average price of $10 Million.  Reread that – each doughnut store was worth $10 Million!  How many doughnut stores have you seen worth $10 Million?  Yeah, me neither.  The trade was obvious – Buy Puts!

It was only a matter of time before investors would lose their taste for doughnuts and the last one left holding the bag would be stuck with only the hole.  The high was near $50, then it sold off over 80% in less than two years.

I’m thinking about putting up a sign outside of my town that says, “Retail Chains – Abandon Hope All Ye That Enter Here!”  But the City Council probably wouldn’t take it too kindly.

Another example of a stock’s price topping in conjunction with the opening of operations in and around Boise would be the home improvement store Lowe’s (LOW).  The company had great quarterly earnings.  Their numbers kept getting better and better.  Understand the new revenue wasn’t fueled by same store growth, but by the launching of new outlets.

With the exception of the local “Mom & Pop” hardware stores, our town was abuzz when Lowe’s announced they were moving into our neck of the woods.  The excitement included prospective shoppers as well as job seekers.  Once again, it made front page news.

Shortly after the chain opened its first big box store, it opened another and another.  Home Depot (HD) wasn’t far behind.  We went from Lowes-less to saturated in months.  In less than three months to be exact.  Lowe’s stock price peaked about the same time they opened their Idaho operations.  It became obvious to me that when a company goes to Idaho, there is nowhere else to grow.  A sure fire indication of a top!

Not long ago, the front page news in the financial markets was Chipotle’s earnings miss and the accompanying sell-off.  Later in the day I had mentioned to my teenage son that Chipotle’s stock was flattened like a tortilla.  He answered with surprise that it didn’t make sense to him, since they just recently opened their first restaurant in the Boise area.  Wish I had known beforehand…

I guess the opening of a single Mexican fast food eatery by the mall doesn’t make the news like it may once have.  And if I would dare to travel to the mall, I might see what’s going on (I avoid the mall at all costs).

But more importantly, I need to have conversations with my children on a higher level.  Instead of answering their, “Dad, can I have some money to eat with my friends?” with the concerned parental, “Which friends?”  I need to ask details on where they are going.  Not be a nosy parent, but to be a stock analyst.  You can learn a lot from your kids!  Including, apparently, when a retail company has reached Market Saturation and their stock is getting ready to tank!