Monthly Archives: September 2011

Dow Theory: Bear Market Downside Target

On August 2, 2011, we received what is widely understood to be a Dow Theory bear market indication. According to Dow Theory, a bear market indication shall remain in place until counteracted by a bullish indication. The middle ground, where there is not a new bear market confirmation nor a new bull market signal, is generally considered a range or a “line.”

On August 9, 2011, we presented what we believed to be bear market rally targets according to Dow Theory. In the comment section of that same article, we revised the bear market rally targets based on the low of the Dow Industrials set on August 10, 2011.

The first bear market rally target, which seems next to impossible for the Dow Industrials to stay above, is 11,416.80. This level was only the first of five upside targets that would need to be breached for any prospect that a renewed cyclical bull market is in the works.

A confirmation of the bear market would be signaled if the Dow Industrials and Dow Transports were to fall below 10,719.94 and 4,149.94, respectively.

According to Dow Theory, we are still in a bear market and the early unconfirmed indications are that we may be headed to the 9,686.48 level.

Buffett Prepares His Exit

In a Market Watch article title “Buffett’s Berkshire Buyback Part of Exit Plan”, it was announced that Berkshire Hathaway (BRK-A) will buy back shares of its Class-A and Class-B shares. In the article, it was also mentioned that “the plan also essentially provides for ‘an unlimited and perpetual program.’” This suggests that the shares of Berkshire Hathaway will continuously be bought under specific conditions.
We’re in perfect agreement that the current plan to repurchase Berkshire Hathaway (BRK-B) stock along with the introduction of a select team of managers is part of the strategy to phase out Warren Buffett’s involvement in the company. However, we think that the most overlooked part of Buffett’s departure plan was the purchase of Burlington Northern Santa Fe (BNI).
For a long time, Warren Buffett has been outspoken against the ownership of airline shares due to “…significant capital to engender the growth, and then earns little or no money.” Therefore, it would seem out of character to purchase a company in an industry synonymous for many of the same attributes as airlines. However, the purchase of a railroad company has two significant advantages that are not afforded to most corporations in the United States.
First, a quirk in the rules for railroads allow them to not have to liquidate in bankruptcy, if that were to occur. After Buffett is gone, whoever is in charge can bumble with some derivative instruments that, for unforeseen reasons, blow up. If the blow up were large enough, it could trigger the need to file bankruptcy to get Berkshire Hathaway’s house in order. The clause in the Interstate Commerce Commission (ICC) and Bankruptcy Act allows for railroads not to liquidate if faced with bankruptcy proceedings. This protects Berkshire Hathaway from having to sell off valuable assets while the company re-emerges out of bankruptcy.
The second significant succession strategy of a railroad has to do with what is called “compulsory mergers.” This requirement allows the ICC and a railroad that has gone bankrupt to merge with another company on terms drawn up by the ICC, the bankrupt company and the acquiring company.
Since the railroad industry, like the airline industry, is synonymous for bankruptcy, BRK gets to take advantage of the "compulsory" mergers rule under section 77 of the Bankruptcy Act. This rule gives the ICC "...control over formulating a plan for the reorganization of an insolvent railroad."
Knowing that bankruptcy is only just around the corner in the next economic purge, Berkshire Hathaway can absorb other rails with absolute impunity. Even better, "...Section 5 of the Commerce Act, which governs mergers of solvent railroads, give the merging carriers primary control over the formulation of a merger plan." Could you imagine structuring your own deal of a merging rail that is going bankrupt?
There is a lot of precedent for these laws in the structuring of many railroads.  In fact,  Chicago, Burlington and Quincy Railroad and Northern Pacific Railway (independent companies before their merger) have had their days with aspects of these rules before merging. Because railroads go bankrupt often, there are many examples of how this works. In one "merger," an acquiring railroad "bought" $1.9 million of claims against the state of Florida at a cost of $5,000 from another railroad facing bankruptcy. In our examination of the topic, we have seen assets worth even more being given away for $0.00 as part of a compulsory merger. 
Because Buffett has been outspoken against the ownership of airline shares due to the general lack of profitability and high propensity to go bankrupt, it seems out of character to purchase a company in an industry synonymous for the same attributes. We believe that Buffett’s purchase of Burlington Northern Santa Fe (BNI) was a critical piece of the succession strategy laid down for the benefit of current and future shareholders of Berkshire Hathaway.


  • Berkshire Hathaway 2007 Annual Report. Page 8. 2007 Report here 
  • Altman, Edward I. Predicting Railroad Bankruptcies in America. The Bell Journal of Economics and Management Science. Vol. 4, No. 1 (Spring, 1973), pp. 184-211.
  • The Yale Law Journal. "'Compulsory' Mergers under Section 77 of the Bankruptcy Act". Vol. 64, No. 2 (December 1954). page 282-292
  • Bedingfield, Robert, “Top Officer Quits at Penn Central in Cash Squeeze”, New York Times, June 9, 1970. page 1.
  • Schroeder, Alice. The Snowball. Bantam Books, New York. 2008.

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In the News: September 25, 2011

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Nasdaq 100 Watch List: September 23, 2011

Below are the Nasdaq 100 companies that are within 5% of their respective 52-week lows. Stocks that appear on our watch lists are not recommendations to buy. Instead, they are the starting point for doing your research and determining the best company to buy. Ideally, a stock that is purchased from this list is done after a considerable decline in the price and rigorous due diligence.
Symbol Name Price P/E Div/Shr Yield P/B % from low
TEVA Teva Pharmaceutical 35.26 10.08 0.79 2.10% 1.33 0.74%
ESRX Express Scripts 38.71 15.86 0 0 10.55 0.91%
FISV Fiserv, Inc. 49.65 16.28 0 0 2.27 1.85%
NIHD NII Holdings, Inc. 29.73 12.08 0 0 1.36 2.02%
XRAY DENTSPLY 31.24 16.36 0.2 0.60% 2.13 2.49%
EXPD Expeditors Intl of Was 40.45 23.11 0.5 1.20% 4.52 2.98%
QGEN Qiagen N.V. 13.45 24.45 0 0 1.2 3.07%
VOD Vodafone Group P 25.08 10.72 1.92 7.60% 0.93 3.17%
PCAR PACCAR Inc. 34.06 17.29 0.72 2.00% 2.07 3.21%
NFLX Netflix, Inc. 129.36 32.82 0 0 20.22 3.47%
AMAT Applied Materials 10.59 7.3 0.32 2.90% 1.6 3.93%
URBN Urban Outfitters 23.41 15.85 0 0 2.76 3.95%
PAYX Paychex, Inc. 26.22 18.46 1.24 4.70% 6.27 4.38%
BMC BMC Software, Inc. 38.85 15.34 0 0 4.16 4.46%
RIMM Research In Motion 21.32 3.89 0 0 1.12 4.46%
JOYG Joy Global Inc. 65.01 11.84 0.7 1.00% 3.57 4.52%
INFY Infosys Limited 48.23 17.73 0.85 1.70% 4.33 4.58%
ILMN Illumina, Inc. 41.67 48.12 0 0 4.52 4.65%
VRSN VeriSign, Inc. 28.34 6.32 0 0 N/A 4.96%
Watch List Summary
The following are companies we are tracking from our watch list  this week. First up is Illumina (ILMN) which was last on our watch list on December 19, 2009. After being on our list, Illumina (ILMN) rose 172% at its peak on July 4, 2011. Already ILMN has lost -45.17% since the high in July. While ILMN is still nearly 50% above the December 19, 2009 price, the possibility exists that all the gains that were made could disappear in short order. As an example, anyone who bought ILMN after June 4, 2010 is confronted with a loss. ILMN has a market cap of $5.18B. Levered free cash flow at $146.48 million and enterprise value at $4.75 billion. The stock has lost -47.52% since the high on July 6th and is currently trading at 4.65% above its 52-week low.
Paychex (PAYX) was on our new low watch list on August 15, 2010 when it was within 2% of the 52-week low. Subsequently, Paychex (PAYX) rose 35.80% in 7 months. Employment being what it is, PAYX is trading in a wide range exhibiting a strong base at around $25. According to Value Line, PAYX is trading 30% below the historical fair value. PAYX has no debt and is likely to be an acquisition target if the stock remains at the current price or lower. Already PAYX has fallen 22% from the high set on March 9th bringing the market cap down to $9.49 billion. Prior to 2008, PAYX had a 19-year history of increasing the dividend. Since 2008, the annual dividend has remained at $1.24. PAYX would be purchased at any price below $25.50.
Netflix (NFLX) is going through significant turmoil as reflected in the stock price. Since the high of $298.73, NFLX has plummeted to $129.36 or down -56%. The financials on NFLX are a moving target making it difficult to fully determine the company’s true value. However, the business model is compelling and warrants considerable review. NFLX has a market cap of $6.8 billion and enterprise value of $6.65 billion. After applying Edson Gould’s 1/3 speed resistance line, NFLX will become worth considering at $99.58 and below. A detailed analysis of Gould's speed resistance line applied to NFLX can be found here.
Expeditors International of Washington (EXPD) has fallen to within 2.98% of the 52-week low. According to Yahoo!Finance, EXPD provides logistics services which involves consolidation or forwarding air and ocean freight. EXPD is a highly efficient organization and is trading at 2006 prices as if the company hasn’t averaged earnings of $1.32 in last 4 years compared to average earnings of $0.66 in the period from 2002 to 2005. According to Value Line Investment Survey, EXPD is estimated to have cash flow of $2 for 2011. Historically, EXPD has traded at 25 times cash flow which suggests that the stock should be selling at a fair value of $50. EXPD has increased their dividend every year for the last 18 years.
Watch List Performance Review
The performance of our watch list after one year is to remind us of the possible outcome of investing in the stocks on our list. It is hoped that we can gain greater insight in the investing process and refine that process as we go along. Below is the performance of the top five stocks on our Nasdaq 100 watch list from September 17, 2010.
Symbol Name 2010 2011 % change
PAYX Paychex, Inc. 25.95 26.22 1.04%
INTC Intel Corporation 18.81 22.16 17.81%
AMAT Applied Materials, Inc. 11.02 10.59 -3.90%
YHOO Yahoo! Inc. 13.89 14.71 5.90%
MXIM Maxim Integrated Products 16.91 23.89 41.28%
Avg. 12.43%
NDX Nasdaq 100 Index 1955.83 2206.86 12.83%

All of the top five stocks from last year achieved 25% returns by May 2011.  However, only Maxim Integrated (MXIM) was able to sustain it's price performance that was above the Nasdaq 100 throughout the year.  As a group, the top five fell short of the Nasdaq 100 by -0.40%.

Netflix and Speed Resistance Lines

In a February 9, 1970 Barron’s article titled “600 on the Dow?” William X. Scheinman provides an interesting chart of the Dow Industrials (DJI) that outlines what he believes to be the target level that the DJI would fall to before rebounding. This analysis included macro economic analysis that supported the reasons why the Dow was expected to go to 600.

What is most compelling in Scheinman’s analysis is the accuracy of the target level that the DJI was expected to reach. An element that leaves some unanswered questions is that Scheinman had predicted that the DJI would reach 600 within the same year that the article was written. Of course, The DJI didn’t reach 600 until 1974. This has to do with Scheinman’s cycle analysis which is separate and distinct from the topic which we will examine. Being aware of this inconsistency and leaving it aside for the time being, we’ve attempted to understand the rational and methodology of how Scheinman was able to arrive at 600 on the DJI when it was trading at 755.68.

Scheinman indicates that he obtained his method for accurately predicting the level of the DJI from Edson Gould. According to Scheinman, Gould used what is known as the 1/3 speed resistance line measurement to gauge price change and elapsed time which was purported to be two key determinants of crowd psychology in the market. Scheinman goes on to say:

“Resistance lines decline or ascend at one-third or two-thirds the rates of actual declines and advances between significant bottoms and tops. Resistance to advance or decline is frequently encountered at such trendlines; however, if the resistance line is decisively penetrated, the price-action often tends to accelerate in the direction of the penetration.”
In an example provided by Scheinman below, he plots the bull market of the DJI from 1949 to 1970. In that chart, we can see that the dashed line, the one-third speed resistance line, intersects with the 600 level on the DJI.

As far as we can tell, the 1/3 speed resistance line is calculated by dividing the peak of the market move by 3.  To be as conservative as possible, we’ve added the 1/3 speed resistance figure to the low of the first major decline in the bull run.  In this case, the first major low in the bull market from 1949 to 1966 was at the 1953 low of DJI 254.  The peak is indicated to be 1001 (1001/3=333.66).  Then we add 333.66 to 254 arriving at a figure of 587.66.  In order to account for the extremes, we assume that 1/3 the peak is the point at which the market finally settles.  In this case, 1/3 of the peak value is 333.66.  We feel that the conservative and extreme values help to establish a range which a market or stock that has had a near parabolic rise will finally settle at or near. 

According to our calculations for the market run from 1949 to 1966, 587.66 and 333.66 were the conservative and extreme downside targets for the market, respectively.  However, in the article, Scheinman says that the potential worst-case scenario level would be 597.61.  For the most part, Scheinman’s estimate was fairly accurate in terms of where the reversal in the market occurred.  The bottom in the stock market took place on December 9, 1974 at the 579.94 level.

In the chart of the Dow from 1945 to 1976 below, it should be noted that a large amount of “overshooting” of the 1/3 speed resistance line occurred when the low did take place in 1974 instead of 1970 as predicted by Scheinman.  In the case of the Dow, the index overshot the 1/3 speed resistance line in 1974 by 15%.  However, the price was well within the established, albeit wide, range of 587.66 to 333.66.

We decided to see how consistent the 1/3 speed resistance line would be if applied to three different situations.  First, we’ll review the bull market in the Dow Industrials (DJI) from 1982 to 2007. Next, we’ll run this model using the Philadelphia Gold and Silver Index (XAU) from the bear market bottom of 2001 to the present.  Finally, we’re going to see how this model works against Netflix (NFLX), a member of the Nasdaq 100, in a real-time example.

In the case of the bull market run from 1982 to 2007, we divided the peak of the market at 14,164 by 3 and arrived at 4721.33.  We then added 4721.33 to the first major low in the market after the beginning of the bull market which was in 1987 at 1738.74.  The sum of the two figures is 6460.07 for the conservative and 4721.33 for the extreme scenarios. 

When we review the actual bottom in the DJI in 2009 of 6547.05 we can see that the difference between the most conservative estimate and the 2009 low was off by 86.98 points.  There is no instance of the DJI overshooting the 1/3 speed resistance line.  Although coming within 1.5% of an estimated target seems exceptional, the real challenge becomes, would an investor commit money to an investment before the price level actually hits a projected target?  Once invested, could an investor stomach a further decline of 27% or more? [(6460.07-4721.33)/6460.07=26.92%]

In the case of the bull market run in the XAU Index, we divided the peak of the index at 206.37 in 2008 by 3 and arrived at 68.79.  We then added 68.79 to the first major low in the index after the beginning of the bull run, which was at 49.83 on November 19, 2001.  The sum of the two figures is 118.62.  When we contrast the difference between the two numbers, 118.62 and the actual low of 65.72, we see that conservative estimate was accomplished, however a further decline of 45% to below the extreme level was established instead.  Reasonably near the extreme end of the range, but who is willing to hold on after a 45% drop?
Finally, in reviewing the chart pattern of Netflix (NFLX), we have the peak of NFLX at $298.73.  The conservative estimate for the stock is that it would fall to $148 which has already taken place.  The extreme downside target would be $99.58.  Because of the nature of the rise, we believe that Netflix (NFLX) is slated to fall at least to the $99.58 level. 
If for any reason investors become interested in buying Netflix (NFLX), the ideal time to do it appears to be at a price at or below $99.58.  However, the difficulty may be that the sentiment that pushed the stock price to $298.73 would likely be just the opposite to push the price down.  Only time will tell whether Netflix is going to conform to technical patterns created by Edson Gould.
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