The Bible of Trend Following

How To Tell An Uptrend In Stocks Is Over?

Supposedly no one ever rings a bell…when an uptrend is over.

No one knows how deep and long a correction will go. That is why I am a cautious investor.

The stock market typically signals a recession long before the trouble is obvious. According to the National Bureau of Economic Research, the 16-month recession in 1973-74 began in November 1973. However, the Dow Jones industrial average peaked in January 1973, beginning a series of lower lows 10 months before the recession’s technical start.
The bear market didn’t hit rock bottom until December 1974 — about 47% off the January 1973 high.

How will the individual investor know when to begin selling stocks?

Personally I use moving averages on the SPY and QQQ. More so I count distribution days. Currently we are at 8 on the QQQ. I exited most of my position when we had a clustering of 4 several weeks back. A cluster of distribution days will serve as the signal to start scaling back.

When you trade, you trade your personality. You need to have rules that match your personality and risk tolerances…

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5 year Old Bull – How Much Longer can the Party Last?

How much longer can this bull market continue? Anyway you look at it, this is a time to be cautious. This is an old bull market and markets do not go up forever. With all the QE for ever this will be ending shortly. So what do you do? At this time it is prudent to be cautious. It is not a time to be on margin. Follow a complete trading plan and look to avoid big losses.

Currently we have 7 Distribution days on the QQQ and now 5 on the SP500. These are not positives for the market. In my own trading I am almost out of the market, however this can change on any day. The Russell is beyond struggling.

At times like this one needs a complete trading plan; otherwise they can enjoy having 50% draw downs as in the past 10 years.

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Trend-Following Through the Rates Cycle​​​ Pimco Study

I have a colleague in London who sent me this interesting article. It is from Pimco…all credits to them…

Some investors have been concerned that the historical success of trend-following – a quantitative strategy that seeks positive returns by capturing momentum across major asset classes – might unravel in a period of range-bound or rising interest rates.
•We created a simple, transparent and hypothetical trend-following model that trades 20 markets and back-tested it over the period 1962 to 2013.
•Our results suggest that trend-following strategies have the potential to generate positive returns amid rising rates – and indeed, across all interest rate environments.

Article Main Body
Some investors have been concerned that the historical success of trend-following – a quantitative strategy that seeks positive returns by capturing momentum across major asset classes – would unravel in a period of range-bound or rising interest rates. PIMCO’s New Neutral thesis anticipates that interest rates will remain lower for longer. Eventually, ​however, rates are likely to rise from today’s rock-bottom levels. Even so, history shows that trend-following strategies have the potential to generate positive returns amid rising rates – and indeed, across all interest rate environments.

Most asset classes have benefited from 30 years of falling interest rates, as future cash flows have been discounted at steadily lower rates, boosting present values. Accordingly, passive long-only strategies now face a challenge in generating positive returns in a period of range-bound – or worse, rising – rates, which could partially reverse this discounting windfall.

Trend-following strategies, which take long or short positions across equity, bond, currency and commodity futures markets consistent with trends in these markets, rode the long downward trend in rates and often profited. However, unlike most passive strategies (and many active ones), trend-followers have no fixed directional bias and can short any and all markets that are falling. By their nature, trend-followers will often miss turning points. But whether markets are rising or falling, if trends are persistent and strong, trend-following strategies are designed to seek profits.

Figure 1 illustrates the point. It compares hypothetical excess returns of a simple trend-following strategy model with those of U.S. equities and five-year note futures from 1962 to 2014. The 14 years in which rates fell 100 basis points (bps) or more had the strongest trend-following returns, averaging 10.3%. However, the 12 years in which rates rose 100 bps or more still had a positive average excess return of 4.5%. This should be compared with the -4.9% estimated excess return on Treasury futures during those years. Interestingly, equity markets had excess returns of about 6% in all three interest rate regimes.

Figure 2 shows the asset class breakdown. Contributions were well balanced, especially in the falling rate and range-bound years. This shows that hypothetical trend-following returns during the last 30 years were not driven solely by interest rate positions. In the rising rate years, the contributions from rates and equities were much smaller, but still positive. In the example, currency futures generated the largest returns.

Rising rate years are the most informative to examine further, as these are when generating positive returns is generally most challenging. From 1962 to 2014 there were 12 years in which five-year Treasury yields increased 100 bps or more (see Figure 3). During those years, Treasury futures averaged an estimated -4.9% excess return, while U.S. equity market excess returns varied from -17% (1969) to +32% (2013), averaging 6.1%. Trend-following returns are typically back-loaded: The model tends to lose money initially upon entering a period of rising rates, but once a new trend is identified, positions switch and may profit. The years 1979, 1994 and 2009 were the exceptions over this sample. In each case, whipsaw in the equity market led to losses.

Three periods are worth examining closely. In the five-year period from 1977 to 1981, five-year yields rose 100 bps or more in each year. In 1977, the trend-follower initially lost money, but then profited strongly as the trend persisted. In the second example, 1994, yields moved too fast for the trend-follower to profit, and whipsaws in equity markets led to negative returns. In the third example, 2013, yields again moved too fast for the trend-follower to catch the move and profit, but other asset classes, notably equities, did display significant trends, potentially delivering overall positive returns for the strategy.

Example 1: 1977-1981
The high inflation era of the late 1970s generated significant interest rate volatility and a period of persistently rising rates. From 1977 to 1981, five-year Treasury yields rose a total of 827 bps, generating an estimated -30% excess return on five-year Treasury note futures. The S&P 500 returned a total 9% excess return over this period. Figure 4 shows the five-year yield path and cumulative monthly excess returns of the simple trend-follower. The contribution to the trend-follower return coming from positions in note futures is also broken out. The hypothetical trend-follower initially lost money in 1977, caught on the wrong side as the prior trends reversed. As the year progressed, however, the interest rate trend persisted, and the trend-follower took short positions in five-year note futures and equities, and short dollar positions in the Japanese yen (JPY) and the British pound (GBP), delivering strong excess returns in the latter half of the year.

The next year, 1979, proved more difficult for the model, with high volatility in equity markets, but it again performed well in 1980 and 1981. Overall, the hypothetical trend-follower could have generated an approximate 34% excess return in total over the five-year period.

Example 2: 1994
The year 1994 witnessed the single-biggest one-year increase in five-year yields during the 1962 to 2014 period – from about 5% at the start of the year to nearly 8% at year-end. In this episode, the trend-follower model was caught off-guard at the beginning of the period, likely generating losses across asset classes. However, equity markets, after initially plunging, recovered strongly into the end of the year, whipsawing the trend-follower. Returns of the hypothetical trend-follower model for the full year were -4.2% (although it is worth noting that the model returned +17% in 1995 after the new trend became persistent).

Example 3: 2013
The last example covers the taper-induced rate spikes of 2013. Over the calendar year the five-year yield increased around 100 bps, but the majority of this occurred between May and August. This is another good example of how the trend-follower can be caught positioned the opposite way when rate spikes are wholly unanticipated. The model was profitable up until May, then lost money during May and June before equity markets surged in the second half of the year; the trend-follower profited from this new trend, ending the year +9%. Rate futures trend-followers ended the year roughly flat.

Unanticipated periods of rising rates may have unpredictable results on multi-asset portfolios and on some popular strategies. No strategy can fully mitigate this, but we find that trend-following strategies do have the potential to exhibit fairly robust returns during such episodes thanks to their ability to take short positions in markets that are falling. Trend-following, by its nature, tends to miss market turning points, and may lose money initially on spikes in rates or in periods of volatile but range-bound rate moves. However, our analysis shows that over extended periods, trend-following has the potential to perform strongly in all phases of the rates cycle, with contributions to that performance coming from all asset classes.

For investors, this property, combined with the strong performance of the simple trend-follower model in equity market drawdowns, should warrant consideration of these strategies in portfolio construction as a diversifier with the potential for positive returns.

Appendix: the simple trend-follower model
For the purposes of this analysis we set up a simple, transparent and hypothetical trend-following model. The model trades 20 markets: five each in equity index, bond, currency and commodity futures. The model trades once per week, taking a long position if the current futures price is above the one-year moving average price, and taking a short position if it is below. Each position is scaled inversely to the recent 3-month daily realized volatility of the contract, and the overall model is scaled to target 10% volatility, using trailing 10-year windows to estimate volatility. Some futures markets were unavailable in the early parts of the sample. In those periods, risk allocated to each asset class is kept roughly constant over long periods of time by scaling up the underrepresented sectors. Over short periods, risk can be skewed to some asset classes. Fixed transaction costs, estimated from available market data for each futures market of between 1 bp and 10 bps, are subtracted from returns.

Extended hypothetical futures time series are constructed for S&P 500 futures, five-year note futures and currency futures (JPY, DEM, AUD, GBP) before actual trading in those futures markets began. For S&P 500 futures we use daily excess return data from the Ken French database for the top 30% of U.S. stocks with reinvested dividends. For five-year note futures we use the Gurkaynak, Sack, Wright constant maturity Treasury yield data set to estimate daily returns, including roll down and carry. Delivery option effects are not included in the modelling but would not be expected to bias results. Proxy currency future returns are calculated using “risk-free” rate data from Dimson, Marsh and Staunton and Bloomberg spot rates starting in 1973. ​

Article Disclaimer​​
The “risk-free” rate can be considered the return on an investment that, in theory, carries no risk. Therefore, it is implied that any additional risk should be rewarded with additional return. All investments contain risk and may lose value.

Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Entering into short sales includes the potential for loss of more money than the actual cost of the investment, and the risk that the third party to the short sale may fail to honor its contract terms, causing a loss to the portfolio. Equities may decline in value due to both real and perceived general market, economic and industry conditions.Managed futures contain heightened risk, including wide price fluctuations and may not be suitable for all investors. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Derivatives and commodity-linked derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Commodity-linked derivative instruments may involve additional costs and risks such as changes in commodity index volatility or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Investing in derivatives could lose more than the amount invested. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. The models evaluate securities or securities markets based on certain assumptions concerning the interplay of market factors. Models used may not adequately take into account certain factors, may not perform as intended, and may result in a decline in the value of your investment, which could be substantial.

No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Hypothetical or simulated performance results have several inherent limitations. Unlike an actual performance record, simulated results do not represent actual performance and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated performance results and the actual results subsequently achieved by any particular account, product or strategy. In addition, since trades have not actually been executed, simulated results cannot account for the impact of certain market risks such as lack of liquidity. There are numerous other factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results.

The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. It is not possible to invest directly in an unmanaged index.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark or registered trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. THE NEW NEUTRAL and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Pacific Investment Management Company LLC in the United States and throughout the world. ©2014, PIMCO.

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The S&P 500 is up 200% since the March 2009 Lows- What to Do Now!- As per Mike

I have a colleague who sent me this email. I thought to share it as most investors I believe will get it wrong…

The S&P 500 is up 200% since the March 2009 lows.

That’s great if you’ve been fully invested since then, but let me ask you one question…

When do you ring the register?

Now? What if stocks keep going up?

When your buddy at some fancy bank or hedge fund tells you to?

Never because you “believe” stocks always go up and you’re “in for the long-term”? How’d that work out for your parents in 2008 and 2000? Both times, they took 50% drawdowns.

From 2000-2013, stocks went nowhere – earning people no money. None.

What if stocks start falling? Do you sell when they drop 10%? 20%? 30%? 40%? 50%?

Most people have no idea when to sell. Most people never sell. They don’t want to think about it or take the 20 seconds to click the two buttons in their Schwab account to protect their money. So, they get pummeled and frantically watch CNBC for answers.

Don’t be these people. If you have an advisor, ask him what the plan is. If he doesn’t have a good answer, fire him ASAP.

If you invest directly in a hedge fund, ask the manager what the selling procedure of his strategy is. If he doesn’t answer clearly, bust a move outta there. He probably doesn’t have one.

Having a selling plan protects you when the sh*t hits the fan.

It’s that simple.


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All Time New Highs & Multi Year Highs only to add another Distribution day-The return of the Hindenburg Omen signal

While everyone was jumping up and down on Alibaba the internals of the stock market took another hit. Another distribution day was added to the Nasdaq making a total now of a cluster of 5. I exited at a clustering of 4 distribution days even though the moving averages and % increases & drops have still held.

Fridays action of a reversal off new highs is a very negative sign. All the major averages closed near the bottom of their trading ranges and volume was much higher across the board. Overall the market is looking weak. Few stocks are breaking out and producing meaningful gains and the major averages seem to be struggling. We are also seeing the return of the Hindenburg Omen signal. We had one yesterday and just missed one earlier this week. This indicator occurs near the end of cyclical bull markets. We had a bunch of them in 2007 near the end of the last cyclical bull and several more occurred earlier this year. We are now seeing them again. The Hindenburg Omen is not perfect as nothing is. The Hindenburg Omen is based on based on Norman G. Fosback’s High Low Logic Index (HLLI).The value of the HLLI is the lesser of the NYSE new highs or new lows divided by the number of NYSE issues traded, smoothed by an appropriate exponential moving average.

From Wikipedia’s page on the Hindenburg Omen…

These criteria are calculated daily using Wall Street Journal figures from the New York Stock Exchange for consistency. (Other news sources and exchanges may be used as well.) Some have been recalibrated by Jim Miekka to reduce statistical noise and make the indicator a more reliable predictor of a future decline.

The daily number of NYSE new 52 week highs and the daily number of new 52 week lows are both greater than or equal to 2.8 percent (this is typically about 84 stocks) of the sum of NYSE issues that advance or decline that day (typically, around 3000).[2] An older version of the indicator used a threshold of 2.5 percent of total issues traded (approximately 80 of 3200 in today’s market).
The NYSE index is greater in value than it was 50 trading days ago. Originally, this was expressed as a rising 10 week moving average, but the new rule is more relevant to the daily data used to look at new highs and lows.
The McClellan Oscillator is negative on the same day.
The number of New 52 week highs cannot be more than twice the number of new 52 week lows (though new 52 week lows may be more than double new highs).
The traditional definition requires each condition to occur on the same day. Once the signal has occurred, it is valid for 30 days, and any additional signals given during the 30-day period should be ignored, or one signal does not mean very much, but more than one is a confirmed signal, or five or six are even more important. During the 30 days, the signal is activated whenever the McClellan Oscillator is negative, but deactivated whenever it is positive.[2]

Some users of the omen may choose to view the 30 day limit as “working days” and not “calendar days”, arguing that the global finance market works on a weekday (Monday to Friday) schedule—leaving about 100 hours where only limited sharemarket trading takes place.

As a rule, the shorter the time-frame in which the conditions listed above occur, and the greater the number of conditions observed in that time frame, the stronger the Hindenburg Omen. If several—but not all—of the conditions are repeatedly observed within a few weeks, that is a stronger indicator than all of the conditions observed just once during a 30-day period.[3]

Possible weaknesses[edit]
Structural: New highs and lows are being affected by exchange-traded funds (ETFs). The last two times Hindenburg triggered was due to Bond ETFs making new highs or lows. If ETFs were removed, Hindenburg would not have triggered. When the Omen was originally designed there were no ETFs, so triggering behavior in the 2010s is not the same as in the 1990s to mid-2000s.

Theoretical: It is theoretically possible for those with unlimited financial resources and minimally regulated automated trading systems to keep the omen from triggering. This has been postulated by the creator of the “Vergulde Draeck” Omen.

Triggering: To eliminate false positives some technical analysts have imposed the condition that the Hindenburg Omen

must be triggered three times in a row within a month from the first triggering event for said initial trigger signal to be considered to be valid (i.e. requires double confirmation)
is only valid when “all tightly coupled triggerings are within a fortnight”
will indicate a possible future downturn or correction, depending on the magnitude of any “one off” triggering
From historical data, the probability of a move greater than 5% to the downside after a confirmed Hindenburg Omen was 77% [The Wall Street Journal 8/23/2010 article cited below states that accuracy is 25%, looking at period from 1985], and usually takes place within the next forty days. The probability of a panic sellout was 41% and the probability of a major stock market crash was 24%. Though the Omen does not have a 100% success rate, every NYSE crash since 1985 has been preceded by a Hindenburg Omen. Of the previous 25 confirmed signals only two (8%) have failed to predict at least mild (2.0% to 4.9%) declines.

Because of the specific and seemingly random nature of the Hindenburg Omen criteria, the phenomenon may be simply a case of overfitting. That is, by backtesting through a large data set with many different variables, correlations can be found that do not really have predictive significance. The Omen is at best an imperfect technical indicator that is a work in progress.

Recent occurrences[edit]
In 2013, a Hindenburg Omen signal was initially observed on April 5. Ten days later on April 15th, a second Omen nearly materialized, but narrowly failed to do so as the NYSE 52-week lows on that day were 2.749%, just shy of the necessary 2.8% or greater. As such, the April 5th Omen failed to be confirmed by a repeat Omen within a period of 30 days, which is generally considered a requirement for validation. On May 31, the Hindenburg Omen again appeared; this time with proper validation in the form of three subsequent Omens occurring on June 4, June 10 and June 19. The Omen re-emerged within the first two weeks of August in a series of six occurrences in three back-to-back sets of Omens. The first group of Omens occurred for two consecutive days on August 5 and 6, the second pair on August 8 and 9 and the most recent on August 13 and 14.

Sep 19, 2014: Weekly 10SMA rising, 128 New Highs, 102 New Lows, McClellan -89.797
Dec 11, 2013 and again on Dec 16, 2013 where the OSC stayed negative in between those dates and is still negative as of Dec 17, 2013 (the 50 day prior higher high seems to be valid but can someone confirm these two occurrences.)
July 23, 2012. The Omen was triggered in 2012 on July 23 and was immediately confirmed by a subsequent Omen the next day on July 24 and by a third on July 25th forming a consecutive three-day cluster.
August 12, 2010: The Omen’s creator, Jim Miekka, considered the Omen officially triggered on this date with 92 and 81 new 52-week highs and lows, respectively. The McClellan Oscillator was a negative -120.03 and the 10-week NYSE moving average was rising; the market closed above its open of 50 days prior (May 27).[4] In the ensuing week, the Omen narrowly missed confirmation twice (August 13 and 19).
August 20, 2010: According to the Wall Street Journal, the omen was confirmed on Friday, with 83 new 52-week highs and 95 new 52-week lows on the NYSE. The McClellan Oscillator was a negative -106.46 and the 10-week NYSE moving average was rising; the market closed above its open of 50 days prior (June 11).[5]
August 24, 2010: 166 New Lows, 87 new Highs, McClellan Oscillator was negative, but the 10 week average began to fall. (Non-Confirmation.) (Although the 12 week average is still positive.)
August 25, 2010: 150 New Lows, 90 new Highs, McClellan Oscillator was negative, but again the 10 week average was falling (Non-Confirmation.) (Although the 12 week average is still positive.)
August 31, 2010: 86 New Lows, 164 new Highs, McClellan Oscillator was negative, and the 10 week moving average was up slightly 8.86 (0.13%) but falling (non-confirmation)
December 14, 2010: 113 New Lows, 179 New Highs, 3063 Advancers+Decliners, McClellan Oscillator was negative (-5.36), NYSE Composite Index closed at 7855.22 vs 7272.53 50 trading days prior (October 4, 2010), and the 10 week moving average was rising.
December 15, 2010: 89 New Lows, 156 New Highs, 3044 Advancers+Decliners, McClellan Oscillator was negative (-22.59), NYSE Composite Index closed at 7798.78 vs 7434.18 50 trading days prior (October 5, 2010), and the 10 week moving average was rising. This represents a single confirmation.

We are in a 5 year old bull market with optimism flowing. All too many forget how bad 2008 was. I am not a bull nor a bear. I am a realist and try to read the market as best as I can. The Fed’s QE forever has supported the market for a long time and it is likely the bull would have ended earlier without it. I don’t know when it will end, but when it does it is likely to be ugly.

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SP Hits New Highs- So Much for 4 Distribution Days…

Yellen has overcome the time tested rule of clustering of distribution days….The SP 500 hit new highs. The trend is up. QE forever. However at some point this will end very badly. It always does. That is why one needs to trade with a complete trading plan.

Regardless of opinions trading plans must be followed even though we are in a late stage bull and intuitively does not feel like a strong market. Meaningful moves in individual stocks remain rare and until that changes it will be difficult to make real progress in the current rally.

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Chart Pattern Guide Lines

Regardless of what you trade this chart pattern sheet might assist your trading. However it is only part of your trading plan…You need to know how much to buy or sell…when to exit with a loss or profit…and follow your plan with discipline…



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Wide-Moat Alibaba

I had this emailed to me and wanted to share…

By R.J. Hottovy, CFA | 09-17-14 | 05:00 PM | Email Article
Alibaba’s (BABA) long-awaited initial public offering is expected to price on Sept. 18 and trading set to begin the next day. The company recently raised its price to between $66 and $68 per American depository share (ADS) compared with its initial $60-$66. Perhaps learning lessons from Facebook’s IPO, Alibaba’s current pricing range strikes us as conservative, and we do not believe the valuation fully reflects the features that make the wide-moat Alibaba investment story unique. Based on 2.5 billion shares outstanding after the offering (assuming underwriter options have been exercised) and a discounted cash flow-derived equity value of $223 billion, we assign Alibaba a fair value estimate of $90 per ADS.
Nevertheless, we acknowledge that there are several geographic, regulatory, and corporate structure risks inherent to investing in Alibaba, which are reflected in our high uncertainty and poor stewardship ratings. As such, we believe the IPO is most appropriate for investors with higher risk tolerance looking to increase their exposure to China’s emerging middle-class consumer base and its online commerce, mobile commerce, technology, and logistics industries.
Key Takeaways
Reaffirming our wide moat and stable moat trend ratings. Alibaba’s recent top-line growth trends have been supported by an increase in the number of active buyers and sellers, supporting the network effect underpinning our wide moat rating. We continue to believe that structural differences in China’s retail industry and Alibaba’s mobile investments will protect its network effect, even as China moves from a consumer-to-consumer to a business-to-consumer e-commerce market, resulting in a stable moat trend.
Our $90 per ADS fair value is based on a revenue CAGR of 32% and operating margins expanding to 50.2% from 47.5% over the next five years. Our top-line assumptions are due to several macroeconomic, socioeconomic, regulatory, and industry growth drivers, while a scalable third-party platform should allow Alibaba to generate margins well ahead of its peers.
Assigning Alibaba high uncertainty and poor stewardship ratings. We’ve assigned a high uncertainty rating based on competitive, regulatory, and execution risks, while our poor stewardship rating balances management’s solid execution with concerns about its variable interest entity (VIE) structure, partnership committee, and Alipay transference.
Conservative IPO Pricing Range Underappreciates Alibaba’s Longer-Term Potential, but Investors Must Understand the Risks
With Alibaba’s IPO expected to price on Sept. 18 and trading expected to commence the following day, we are publishing this piece as a supplement to our earlier report A Powerful Network Effect in a Rapidly Growing Industry Makes Alibaba a Rare Find, which provided a preliminary look at the company’s moat, moat trend, and valuation. The valuation assumptions behind our discounted cash flow model remain largely intact, with only modest adjustments to our preliminary enterprise and equity value based on incremental technology infrastructure, product development, and marketing investments, but also slightly higher long-term operating margins stemming from an increase in monetization trends.
We have assigned Alibaba an initial fair value estimate of $90 per ADS, which implies an enterprise value of CNY 1,329 billion ($214 billion) and an equity value of CNY 1,387 billion ($224 billion). Our fair value estimate represents an attractive 32%–36%% premium over Alibaba’s latest expected pricing range of $66 to $68 per ADS. In this report, we take a closer look at the four pillars of Morningstar’s approach to evaluating equities and how they apply to the Alibaba investment thesis: 1) economic moat and moat trend; 2) valuation; 3) uncertainty; and 4) equity stewardship. While we view Alibaba’s initial pricing range as conservative relative to the company’s tremendous growth potential, we believe investors must incorporate a wide margin of safety given Alibaba’s unique set of geographic, regulatory, and corporate structure risks, which we evaluate in this report.
Pillar 1: Reaffirming Our Wide Moat Rating Based on Alibaba’s Network Effect, Brand Intangible Asset, and Scalable Model
We have assigned Alibaba a wide moat rating largely because of a strong network effect, where the value of the platform to consumers increases with a greater number of sellers (and vice versa). A network effect is among the rarest of the five sources Morningstar uses to assess a company’s economic moat and one of the most powerful, as it can often result in a multidecade period of excess economic returns. Alibaba’s network effect is unusual, having been established in an industry (China e-commerce) at a relatively early stage in its life cycle. Many of the other companies that Morningstar has assigned network-effect moat sources participate in more mature industries.
Alibaba’s network effect is based on operating some of the most popular online marketplaces in China, including Taobao, Tmall, and Juhuasuan, which together generated a gross merchandise volume, or GMV, of CNY 1,678 billion ($271 billion) in fiscal 2014, more than Amazon (AMZN) and eBay (EBAY) combined (which accounted for $116 billion and $88 billion, respectively, based on data from International Data). As a third-party e-commerce platform operator, Alibaba allows millions of buyers and sellers to connect, explore, and transact with each other. The company boasted 279 million active buyers (representing 21% of the total Chinese population) and 8.5 million active sellers for the trailing 12-month period ending June 30.
We Believe Alibaba Is Well-Prepared for Shift from C2C to B2C
Unlike other developed countries where the e-commerce market is dominated by business-to-consumer (B2C) players like Amazon, Tesco, Otto, and others, consumer-to-consumer (C2C) marketplaces accounted for almost 64% of China’s total online shopping GMV in 2013, according to data from iResearch. We expect a more pronounced shift to B2C e-commerce in the years to come as 1) other large domestic and foreign B2C platforms bolster their presence in China; 2) traditional retailers increasingly embrace multichannel models; and 3) Chinese consumers demand higher-quality and branded goods. Although we don’t consider the network effect among Alibaba’s B2C marketplaces to be as strong as its C2C marketplaces, we believe the network effect inherent in the Taobao Marketplace (which is often the first destination for Chinese online shoppers, as shown in Exhibit 1) enriches the company’s entire ecosystem, providing low-cost organic traffic for other B2C marketplaces like Tmall and Juhuasuan while reducing Alibaba’s reliance on a salesforce for marketing services. The Taobao marketplace allows Tmall’s product offering to be listed on its search result pages. By diverting significant buyer traffic to the Tmall marketplace, Taobao helps Tmall gain user traffic in an extremely cost-effective manner. As such, we believe Taobao will be instrumental in helping Alibaba adapt to changes in China’s e-commerce landscape.

Tmall, with its improved product quality assurance and enhanced user experience, has also become an increasingly important revenue driver for Alibaba. According to Alibaba’s latest F-1 filing, GMV on Tmall marketplace grew by 90% and 81% year over year in the past two quarters, respectively. In the first quarter of fiscal 2015, GMV on Tmall accounted for 31% of total GMV on Alibaba’s retail marketplaces in China, up from 13% three years ago. We expect China’s traditional C2C marketplaces to mature further, while demand for high-quality branded products continues to grow. Moreover, as online shopping becomes an increasingly integral part of daily life of Chinese consumers, we believe Tmall will continue to grow faster than Taobao, and the total GMV of Tmall is likely to surpass that of Taobao in the following years.

China’s Offline Retail Market Structure Should Protect Its Network Effect, Supports a Stable Moat Trend Rating
We expect China’s fragmented and underdeveloped offline retail market to insulate Alibaba’s network effect. Per capita retail space in China is significantly below that of developed countries like the U.S., Germany, the U.K., and Japan. E-commerce and mobile commerce adoption has come to a key inflection point in the evolution of the Chinese retail industry, suggesting a very different trajectory relative to retail industries in other developed markets. Given favorable consumer demographic trends and the current state of its supply chain and logistics infrastructure, we believe China’s retail industry will bypass the traditional consolidation stage that most developed countries experienced and move into a channel diversification stage. As a result, we believe vendors will continue to depend on Taobao, Tmall, and Alibaba’s other marketplaces in the years to come, driving increased consumer engagement and supporting our stable moat trend rating.
Competition with and Other Chinese E-Commerce Companies
Has Been Exaggerated We view as Alibaba’s most viable competitor in the long term. However, we consider Alibaba to have a more powerful network effect and a wider moat. We have discussed the competitive advantages and weaknesses of in our previous report and believe it is worth re-emphasizing Alibaba’s competitive strengths and why we think it can defend its leadership over the long run.
First, we believe the network effect of Taobao and Tmall poses a serious challenge for competitors to replicate. In the trailing 12-month period that ended in June, Taobao and Tmall had 8.5 million active sellers and 279 million active buyers, far ahead of’s 38,000 active sellers and 38 million active users during the same period. Alibaba’s ecosystem is not only scalable but also highly interactive. Customers rely on the extensive number of product reviews and recommendations by millions of fellow customers to make purchase decisions. At the same time, merchants of all kinds are attracted to the dominant user traffic of Alibaba’s marketplaces. An annual survey by China Internet Network Information Center shows that product reviews are the first consideration for online shoppers. Alibaba’s marketplaces, with its dominant user base, have accumulated the largest number of product reviews in the past decade.
To improve the monetization rate, has been following Alibaba’s path by introducing third-party merchants to its online marketplace. We have limited confidence in this strategy, since sellers will find Alibaba’s online marketplaces, with much higher user traffic, a more attractive destination. Compared with Tmall, doesn’t appear to offer a significant cost advantage for third-party merchants. Online sellers need to pay a CNY 6,000 annual fee and 3%-10% of gross transaction volume with, while Tmall charges a CNY 30,000 to CNY 60,000 annual fee and a very attractive commission rate of 0.5%-5%. We believe’s competitive advantage lies in the fulfillment capacity of its self-operated online store, though it is unlikely to challenge Alibaba in the online marketplace.

Alibaba’s Network Effect Should Make a Successful Transition Into Mobile Commerce
Increased usage of mobile devices in China will make access to the Internet even more convenient, which should drive higher online shopper engagement over a longer horizon. We anticipate strong mobile commerce growth trends over the next decade, driven by 1) increased mobile device capability investments by e-commerce players; 2) improvements to China’s Internet infrastructure; and 3) greater smartphone and tablet adoption among Chinese consumers. Additionally, we believe Alibaba’s position as the preferred mobile shopping platform among Chinese consumers (aided by the company’s acquisition of mobile browser developer UCWeb) will help to drive increased mobile monetization rates over a longer horizon.
We believe Alibaba’s market leadership at the mobile end will also help protect the network effect behind our wide economic moat rating and stable moat trend. As mobile Internet and smart devices continue to proliferate across China, mobile commerce has been growing at an explosive rate and gradually becoming mainstream. We believe Alibaba’s success in the PC end gives the company key advantages against its competitors in the mobile end. Its trusted brand and self-reinforcing ecosystem convince us that the firm can copy its success to from PC to the mobile market. According to iResearch, Alibaba has been able to expand its market share in the mobile commerce market to 86% in the second quarter of 2014 from 73% in the same period in 2012.

More Than Just a Network Effect: Alibaba’s Cost Advantages and Intangible Assets Also Support Our Wide Moat Rating
Because Alibaba’s various online marketplaces are interconnected, we believe this compounds the company’s network effect, which then breeds other competitive advantages. Essentially, buyers on Tmall’s marketplace could also go to Taobao for a broader range of products, while Taobao users with a strong appetite for branded products could switch to Tmall for a better shopping experience and higher quality. In fact, we believe Taobao diverts a substantial amount of user traffic to Tmall, thereby lowering Tmall’s customer acquisition costs.
The significant economies of scale also allow Alibaba to spread fixed costs over a wider revenue base, making it China’s most profitable e-commerce company. Moreover, through its China Smart Logistics subsidiary (48% owned by Alibaba), the company operates as a third-party platform without taking control of inventories—something that is unlikely to change, in our opinion—adding another layer of cost advantages and driving margins above those of and other competitors.
Pillar 2: Our $90 Fair Value Is Based on a Revenue CAGR of 32% and Operating Margins Expanding to 50.2% from 47.5% Over the Next Five Years
Combining Alibaba’s self-reinforcing network effect, scalable technology and infrastructure, and several favorable macroeconomic, socioeconomic, government, and industry growth drivers, we continue to believe Alibaba offers investors one of the more compelling and sustainable growth stories across our global consumer and technology coverage.
We are initiating coverage of Alibaba with a fair value estimate of $90 per ADS. Underpinning our valuation assumptions is a compounded average revenue growth rate of 32% for the five years between fiscal 2015 and 2019. We believe the major business driver for Alibaba will still be the retail commerce segment in China. Rising spending among online shoppers, a growing user base, and a business mix shift from C2C to B2C will all contribute to the robust revenue growth of Alibaba’s online retail business in China. We forecast a compounded annual average growth of 26% in GMV on Alibaba’s Chinese retail marketplaces, including Taobao, Tmall, and Juhuasuan. The rapid GMV growth is driven by an active buyer base expansion of 20% per year, implying nearly 700 million active buyers, and a 5% annual average growth in average spending per buyer between fiscal 2015 and 2019. We expect the monetization rate to improve as well, as GMV from the B2C marketplace increasingly contributes to the total GMV.

Our estimates also imply that Alibaba’s GMV will outpace China’s overall e-commerce growth (which we estimate at about 26% using data from iResearch), implying market share gains and a strengthening of its network effect in the process.
Despite Expectations of Increased Infrastructure Investments, Alibaba’s Network Effect Lends Itself to a Highly Scalable Model
Although the firm has undeniable potential for operating leverage, we believe continuously intense competition from other e-commerce firms will force Alibaba to continue investing in technology infrastructure, traffic acquisition, and personnel. We therefore expect some contraction over the near term, with gross margins declining to 72.0% in fiscal 2014 because of technology, product development, and marketing investments (compared with 74.5% in fiscal 2013). However, we expect roughly 100 basis points of gross margin improvement annually in the next five years, largely through expense leverage, bringing our 2018 gross margin estimates to approximately 76.0%.
We expect operating margin to decline to 43.0% in fiscal 2015 from 47.5% in fiscal 2014 because the company is currently investing heavily in technology personnel, user acquisition, and developing its mobile products. We project an average of 100 basis points operating margin improvement annually after fiscal 2015 as part of the fixed costs are spread over a growing revenue base.

Our fair value estimate was derived by discounting three-stage cash flows with a weighted average cost of capital of 9.7% and a CNY/USD exchange rate of 6.13. The adjusted return on invested capital for Alibaba averages about 32% in our five-year projected forecast period (the firm achieved ROICs of 33.8% in 2013 and 55.5% in 2014), well above our estimated cost of capital. This supports our wide economic moat rating for the firm. Our fair value estimate of $90 per ADS implies a current fiscal 2015 price/earnings ratio of 47 times and forward a fiscal 2016 price/earnings ratio of 35 times. We acknowledge that the our valuation appears lofty using the traditional multiple-based methodology, but given Alibaba’s tremendous ability to generate cash, promising business prospects, and dominant market position in one of the fastest-growing e-commerce industries in the world, we believe Alibaba deserves a premium valuation. A detailed summary of our financial model can be found in the appendix.
Stress-Testing Alibaba’s Valuation Through Scenario Analysis
Although we are optimistic about Alibaba’s longer-term growth potential, we acknowledge there are a number of company-specific, industry, and regulatory factors that could affect our long-term cash flow projections. Thus, we stress-test our valuation of Alibaba under optimistic and pessimistic scenarios. We believe future revenue and free cash flow growth will be sensitive to the speed of user expansion and improvement in monetization. Because of the increasing presence of rival B2C platforms and emergent technologies that could disrupt industry economics, we must consider a wide range of outcomes with intrinsic value assumptions:
In our bull-case scenario, we model exceptionally successful business expansion of Alibaba through active user acquisition and robust improvement in monetization of its B2C and mobile commerce business. The stronger-than-expected growth in the user base and improvement in monetization rates (particularly with respect to mobile commerce) lead to rapid revenue growth averaging 39% annually for our five-year forecast period compared with 32% in our base-case scenario. The significant potential for operating leverage will also result in faster margin expansion. We therefore expect gross margin to improve to 78% in fiscal 2019 compared with 76% in our base-case scenario. Operating margin will expand to 56% by the end of fiscal 2019, roughly 6 percentage points higher than our forecast in the base case. Our fair value estimate under this bull-case scenario is $132 per ADS.
In our bear-case scenario, we project a more pessimistic outlook for Alibaba’s business expansion, primarily due to the rising challenge from its rivals, including, Suning, and Amazon. We assume more online shoppers are attracted to the efficient delivery service of and high-quality digital content provided by Amazon. The fierce competition will lead to slower-than-expected user growth and relatively underwhelming monetization improvement. The overall result is revenue growth averaging 26% annually over the next five years, 5% lower than the 31% projection in our base-case assumptions. Slower revenue growth also causes less impressive margin expansions. We expect operating margin to improve to 43% by the end of 2019, 5% lower than our assumption in the base case. Our fair value estimate under this pessimistic scenario is $65 per ADS.

Pillar 3: We’ve Assigned Alibaba a High Uncertainty Rating Based on Competitive, Regulatory, and Execution Risks
Despite its clear dominance in China’s e-commerce industry, we assign Alibaba a high uncertainty rating, which captures the range of potential fair value outcomes based on an assessment of the company’s future top-line growth scenarios, operating and financial leverage, and any other events that may affect the business. In Alibaba’s case, we expect the company to face elevated competition, increased regulatory risk, and the threat of the company’s ancillary businesses shifting management’s attention away from its core marketplaces business. We believe investors must assume a healthy margin of safety relative to our $90 fair value estimate before considering an investment, though the current offering price’s discount to our fair value translates into an initial 4-star rating for Alibaba before first-day trading.
We’ve outlined the most pressing risks of investing in Alibaba:
Heightened e-commerce competition in China. In our view, will be Alibaba’s most credible rival over the long run. JD’s competitive strength lies in fulfillment capability, quality assurance, and strategic partnership with Tencent. JD has the largest fulfillment infrastructure of all e-commerce companies in China, including 97 warehouses in 34 cities, 1,808 delivery stations, and 715 pickup stations. The fulfillment infrastructure allows JD to provide same-day and next-day delivery in 111 counties and 622 districts across China, making it attractive to consumers in regional cities where retail infrastructure is less developed. Furthermore, as JD directly sources and merchandises inventory, we believe the company maintains better control over product quality. Going forward, we expect to attract more online shoppers who value delivery time and quality assurance. Although we don’t believe will threaten the network effect behind Alibaba’s wide economic moat over the long term, JD’s rapid expansion could disrupt the business growth and profitability of Alibaba’s marketplaces.

In addition to, Alibaba also faces competition from several domestic and foreign e-commerce companies, including VipShop, Amazon, and Suning. These companies might not have sufficient scale to compete with Alibaba, but they specialize in e-commerce of some specific products or markets. The rapid growth of these smaller players might limit Alibaba’s product categories and offerings expansion.
Increased online and mobile payment regulatory scrutiny. Alibaba’s business is also exposed to regulatory risk. Financial regulators in China have been increasingly scrutinizing online and mobile payment services. Considering that roughly 80% of transactions on Alibaba’s China retail marketplaces were settled through Alipay, any type of regulatory tightening and supervision policy could significantly affect Alibaba’s business operations.
Ancillary businesses and international expansion increase execution risk. Alibaba’s other downside risks include expansion into peripheral businesses, which might distract management and may not materially improve Alibaba’s ecosystem. We also believe the road to overseas expansion will be bumpy for Alibaba. Despite its clear dominance in China, the firm does not enjoy the same network effect and brand recognition in most other countries.
Pillar 4: Our Poor Stewardship Rating Balances Management’s Solid Execution Track Record With Reservations About its VIE Structure, Partnership Committee, and Alipay Transference
Alibaba has a capable and ambitious management team. Founder and executive chairman Jack Ma has been an inspiring leader since the company’s inception in 1999. Under his leadership, Alibaba has emerged to become China’s dominant ecommerce player, accounting for 84% of total transaction volume of the online shopping industry. Over the past decade, Taobao’s ascendance has literally transformed the shopping behaviors of millions of Chinese consumers. Management has also done an excellent job developing and strengthening Alibaba’s wide economic moat by building several other leading online commerce marketplaces, including Tmall, Juhuasuan,, and Alipay. We are confident that Alibaba can sustain its wide economic moat over the long term under the existing management’s leadership.
Despite management’s Proven Capability, We Have Concerns Regarding Alibaba’s Corporate Governance, Which Is Reflected in Our Poor Stewardship Rating
Like many other Chinese Internet companies listed in overseas markets, Alibaba has adopted the variable interest entity structure, or VIE, which is specifically designed to let companies bypass Chinese legal restrictions on foreign ownership in certain sectors. Alibaba’s foreign investors will essentially hold shares of Alibaba’s VIEs domiciled in the Cayman Islands. We don’t expect any legal challenges to VIEs by the Chinese government in the future. However, on rare occasions, if the legitimacy of Alibaba’s related VIEs is found to violate applicable law or regulation, Chinese regulatory authorities might take action against the VIEs, including revoking the business and operating licenses of Alibaba’s subsidiaries or the VIEs, or discontinuing, restricting, or restructuring Alibaba’s operations. Since the Chinese Ministry of Commerce has the jurisdiction to regulate VIEs, we believe overseas investors will have limited legal rights and are likely to lose their investments under this scenario.
In addition, we harbor concerns about the partnership structure that might jeopardize the board’s independence. Alibaba’s partnership is led by a committee of five, including Ma, vice chairman Joe Tsai, and CEO Jonathan Lu. Among the 27 partners, 22 are Alibaba Group executives, while the rest are executives of affiliated companies.
Upon the initial public offering, the Alibaba Partnership will have the exclusive right to nominate up to a simple majority of the members of its board of directors. Any board candidate they nominate is presented to shareholders for voting. If the candidate is not elected by shareholders, the Alibaba Partnership can appoint another candidate, without a vote. That candidate will serve as an interim director until the next annual general meeting, where either the same candidate or yet another nominee proposed by Alibaba partners will stand for election. Despite its minority stake, the Alibaba Partnership essentially controls the board and limits the influence of outside shareholders.
After the IPO, Alibaba Group will enter a voting agreement with two of its major shareholders, SoftBank and Yahoo (YHOO), as they will agree to vote favorably toward the Alibaba Partnership director nominees at the general shareholder meetings. In addition, Yahoo, Ma, and Tsai will all agree to vote in favor of one director, nominated by SoftBank. We believe these provisions could compromise board independence and increase the likelihood of conflicts of interest.
In 2011, the company transferred the ownership of Alipay to a new company— Co., Ltd—which is controlled by Ma, without the approval of Yahoo and SoftBank. Although a settlement has been reached between Yahoo, SoftBank, and Alibaba, we believe this is symptomatic of dubious corporate stewardship.
R. J. Hottovy, CFA, is a director with Morningstar.

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Perhaps this time it really is different, though..Stock Market Margin Debt

Sure Janet Yellen reassures the market and poof the market jumps. No risk any more!!! Buy and hold and simply get rich. Actually was in a meeting yesterday discussing just this. Why do you try to “time the market”? I countered by I would not feel comfortable being down 50% once over 10 years but twice. Or how about waiting countless years for the Nasdaq to reach prior peaks…Even the worlds greatest investor Warren Buffet suffered severe losses. More so in the Great Depression ( I forgot I was told that could not happen any more) it took 25 years to get back…or in 1973 only 12 years…I love it only ..only 12 years…Most people can not live through a 20% draw down let alone wait for 12 years…I mentioned the Japanese stock market which was at a high of 39,000 in 1989. Well, that is not the US market.

As an investor or trader….I know that anything can happen. I am not a bear nor a bull. I try to stay out of big trouble and try to keep my losses small. Not fun as yesterday I exited my long QLD and QQQ only to see them bounce up with the Yellan rally. What I did do was follow my rules. We had a clustering of 4 distribution days and historically this has shown heavy institutional selling.

The market had a good snap back rally yesterday ( relief rally???).The COMPQ and SPY were both higher by .75%, decent up moves.Volume was mixed on the day with the New York showing higher volume and the Nasd having lower trading. It would have been more convincing to see higher volume all around. Leading stocks rallied and that is what you want to see. However the market has suffered some real damage in the last few days and we will have to see some strong heavy volume in both the major averages and quality growth stocks before we can get comfortable that the rally is back on solid ground.

A concerning issue is the level of margin debt. margin debt

According to NYSE’s latest monthly report, investor margin debt increased by $25.8 billion to $464.31 billion. While we did see two consecutive monthly declines in leverage, margin debt has now recovered in a very robust fashion. Without a doubt, the extremes still remain in place and warn that investors are overly exposed to equities,

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Where is the Nasdaq Sitting Currently $QQQ $QLD

Everyone who has been invested in the leading stocks and Nasdaq realized that markets do not just go up. Not just did the Nasdaq go down…it went down hard on large volume. The Nasdaq registered another distribution day making the total currently 4. What is worse is the clustering of the distribution days. We have had 4 Distribution days in the last 9 trading days. Distribution days are were there is institutional selling and often a purveyor of market declines. Leading stocks got hit particularly hard today with the leaders index down by 2.96% on very heavy volume. There was real damage done, particularly to quality growth stocks.The rally is in real trouble now and a defensive posture is a good idea.

Add in the fact we have not had a significant decline in the markets as well as the optimism currently maybe a surprise is on the horizon. However one must take the market day by day especially due to the FED meeting.

Have your own trading plan and have the discipline to follow it!!!

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