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My investing philosophy mostly centers around the Value discipline and GARP- Growth at a Reasonable Price. This blog includes commentary on market conditions as well as fundamental analysis of specific companies. Graduated from Rhodes College with a degree in Business with concentration in Finance & Marketing. Currently working on obtaining the CFA designation. Previously worked in Mortgage Trading for a major bank. Use MS Excel extensively for developing investment models, notably valuation models based on DCF methods.

Tuesday, August 7, 2007 Trading Based on Technical Factors-Not Fundamentals

Amazon shares continue to defy gravity even with increasing amount of discussion stating shares are overvalued. Barron’s (article) has been the latest to opine stating “The Bottom Line: At 56x 2008 EPS estimates, AMZN are too expensive.
Best to take substantial profits and wait for a better deal later on.” I gave a similar opinion in a piece earlier this month (my article) based on my belief that multiples are just too extreme given paltry margins and lofty growth expectations.
While fundamental analysis strongly suggests AMZN is overvalued to peers, I advised against shorting and further added that shares could go higher in the short-term due to price momentum. Amazon has been trading up mostly due to the technical factors underlying trading activity:

1) Buying stemming from short covering
2) Price strength and momentum dissuades profit taking by longs
3) Investor apprehension to go short fueled by sharp gap-ups

Daily volume has averaged about 11 million shares for the 144 day trading period since the start of 2007. Volume exceeded 15 million only 18 days, exceeded 20 million on 14 days, and only 7 times did daily volume exceed 30 million. There were 5 sessions where shares increased more than 5% and only 1 session where AMZN was down more than 5%. Nearly all of AMZN’s move up occurred on 3 days: 2 days following Q1 earnings release & day after Q2 announcement.

4/25/2007: $56.81 + $12.06 (26.9%) 104m
4/26/2007: $62.78 + $5.97 (10.5%) 62m
5/21/2007: $68.30 + $5.00 (7.9%) 36m
7/25/2007: $86.18 + $16.93 ( 24.4%) 60m

AMZN Short Interest (shares): According to
4/13/2007: 48.5m
5/15/2007: 53.9m
6/15/2007: 46.2m
7/13/2007: 40.6m

With YTD daily volume averaging aprox 11m, -6m over the period leading up to the first major break-out, normal volume is quite thin considering there are close to 50m shares short that eventually will have to be purchased. After the first spike on 4/25 short interest increased from April’s 48.5m to 53.9m in May but subsequently declined the following two months. It appears from the short interest rising 11% in May that shorts become more aggressive , thinking if it’s a short at $40 - even more the case at $60. As the data reports, shorts lost resolve and covered 13.3m shares in the time period leading up to the July figure. It will be interesting to see next month’s figure after the huge pop in 7/25. My guess is that short interest will have declined significantly since much of the price jump was probably due to buying associated with decreasing short interest.

Amazon’s Q1 surprise and increased EPS estimates sparked robust share demand as the market acted to price-in the revised expectations. Shares rose almost 38% in two sessions on exploding volume.
Impressive Q2 earnings results accompanied with a brighter than expected outlook again caught the Market by surprise. In the subsequent session, shares rocketed 24% on heavy volume.

Taking advantage of the bombshell dropped on short-sellers, new buyers take a position betting that shares will go even higher stemming from heavy short covering. Some current longs are less hesitant to sell and take profits knowing that the pent-up share demand will push prices up even further. As the price rises, losses snowball for those whom are short. Nasty short-squeezes prompt covering at any price to escape additional punishment. Shorts aren’t concerned about buying at overvalued prices if it results in minimizing potential losses. This creates price-equilibrium distortions since share demand is predicated on supply factors and not expected future cash flows. Thus, we have investors basing buy/sell decisions on supply & demand factors and not necessarily valuation and fundamentals. This implies that the market is inefficient since higher prices foretell even higher prices and in an efficient market past prices do not predict future prices.

In the case of AMZN, we know that higher prices will predict even higher prices since is very probable that demand will swell from: longs buying to lean on the shorts and from shorts buying to get out from underneath the longs. These instances provide some vindication for technicians who claim price / volume data can predict future price moves. In my opinion, the widespread recognition of this pattern creates a self-fulfilling prophecy due to many investors sharing the exact same expectations and acting collectively resulting in the expected price movement becoming the actual price movement.

Even though, future price moves may have been predictable, it would have been rather difficult to exploit fully in the case of Amazon since share prices reacted so quickly to news. As I mentioned earlier, AMZN shares were relatively quiet except for just the handful of sessions surrounding major news events.
The general assumption is that the Market is efficient, if shares overreact to the upside and become overvalued, longs take profits and shorts rush in to make profits. The onslaught of selling pushes shares down to its rational, fair value. The process is reversed for situations when stocks are oversold.

AMZN shares were driven mostly by buying related to technical factors and not fundamental factors. Sure, earnings expectations rose warranting a rise in value, but not to the extent that occurred. AMZN needed the positive news just to support its current price, not causing shares to double and stretching valuations further. Generally, when share prices overact longs sell and short-selling increases thus guiding prices back down to a value reflecting the collective expectation of future cash flows. Longs may be less eager to sell an overvalued stock if they feel technical factors are present to support lofty price levels. Hence, significant short interest representing future demand.

Another tenet of an efficient market is overbought imbalances are corrected by short-selling and profit-taking increasing supply.
Additionally, no matter how outrageous valuations become, after short-sellers are burned once they become apprehensive about making the same mistake again. Thus, there isn’t the proper lever present to adjust overbought shares sporting stretched valuations. AMZN had a sizable short position when the stock was in the 40’s, which increased 11% after the stock shot up to the 60’s yet shares continued to rise and short interest steadily declined. It appears selling pressure has had only a slight impact on AMZN shares.

AMZN Short interest has declined in the last two months reported. That suggests that some of the buying boosting AMZN was from short covering and that shorts have been less sanguine about shorting AMZN. It may be that shorting AMZN is analogous to putting a nail in one’s own coffin: Rising short interest attracts demand from investors attempting to “squeeze” short players anytime there is positive news released.

It just seems most probable that the factors I mentioned above are partly at work regarding Amazon’s doubling in price. With so many voices expressing concern about Amazon’s unjustified valuation, I would expect to see that sentiment come in to fruition by AMZN shares returning to reality. That has yet to really happen; just some observations to think about. It will be interesting to see the upcoming months’ short interest numbers and Amazon’s share price behavior.


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