Don’t fall for the “dead cat bounce”

January 15, 2019

Don’t fall for the “dead cat bounce”

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The longer a market correction lasts, or extends into a prolonged bear market, the more we see stocks drop to incredibly low level versus their historical highs. The market continues to exhibit quite a bit of uncertainty, not only over global growth forecasts, but also whether the global economic slowdown, along with the deleterious effect of tariffs and trade tensions is finally starting to catch up in the United States. While it may not be a given that the market is going to turn bearish, I think that continued uncertainty is going to keep a lid on broad market upside as we move further into the year.

Eventually, that element alone, coupled with last year’s poor performance, could prompt investors to throw up their hands and finally give up any hope of market recovery, bringing to a real close the longest period of economic expansion in a very long time.

Bear markets in particular really have a way of eroding market value, since declines of 50% or more off of index highs have not been uncommon. The market so far remains in correction territory rather than bear market territory, which is making a lot of the stock that are down 20% or more over the past few months to a year look pretty attractive. There is a risk element, however that I think is very important to pay attention to, and to learn recognize. The name the market has used for that risk for decades is “dead cat bounce.” Yes, that sounds macabre, and it is certainly politically incorrect, but my point is not to focus on the alliteration or the imagery the term might call to mind, but on the risk it describes.

Every stock that experiences an extended drop to historically low levels, at some point will experience a period of consolidation and stabilization, where the price will stop dropping and start to show some resilience between short-term highs and lows. The stock might even start to rally a bit against its longer downward trend, increasing speculation that it’s going to reverse that trend and rally back to new highs. That’s where the “dead cat bounce” comes to play – because in many cases, that stabilization proves to be only temporary, a brief calm before the storm comes back to pummel the stock yet again to even deeper lows.

If you’ve followed this blog for a while, you’ve seen me spotlight a lot of stocks that are in exactly this position right now, and that I think could be poised as good long-term opportunities right now. How do I differentiate between what I think is a legitimate value opportunity and a “dead cat bounce?” Part of it lies in a stock’s fundamental strength, but I want to use Chico’s FAS Inc. (CHS) as an example of a stock that I think is much riskier than people might think.

CHS is a name that most people should recognize pretty quickly. Their stores are just about anywhere you can find a mall, and they offer an extensive line of fashionable women’s apparel and accessories. Considering the strength of the U.S. economy over the last few years, and general retail trends that have been pretty healthy, it would seem natural to think that a company like CHS should be enjoying the ride. And yet, over the last two years the stock has declined about 64% from around $15.50 to its current levels just a little above $6. Since December, however the stock has rallied off of trend lows around $4.50, putting its rally from that point at more than 30%. That sounds pretty attractive, and could tempt you to believe the worst might be over. And there are some fundamental elements that are very impressive; even so, I’m less than convinced. Let’s take a look.

Fundamental and Value Profile

Chico’s FAS, Inc. is an omni-channel specialty retailer of women’s private branded, casual-to-dressy clothing, intimates and accessories, operating under the Chico’s, White House Black Market (WHBM) and Soma brand names. The Company is also engaged in the sale of merchandise in its domestic and international retail stores. The Chico’s brand sells private branded clothing focusing on women 45 and older. Chico’s apparel includes the Black Label, Zenergy and Travelers collections. The WHBM brand sells private branded clothing focusing on women 35 and older. WHBM sells clothing and accessory items, including everyday basics, wear-to-work, denim and occasion. It offers black and white color palette. The accessories at WHBM include shoes, belts, scarves, handbags and jewelry. The Soma brand sells private branded lingerie, sleepwear, loungewear, activewear and beauty products focusing on women 35 and older. The lingerie category includes bras, panties, shapewear and swimwear.CHS’s current market cap is $761.9 million.

  • Earnings and Sales Growth: Over the last twelve months, earnings declined by nearly -62% while revenues increased about -6%. The picture in the last quarter is equally negative. CHS’s margin profile is very narrow, which isn’t all that alarming for a Specialty Retail stock, but is also appears to be deteriorating; over the last twelve months, Net Income as a percentage of Revenues was only 3.6% and declined in the last quarter to only 1.3%.
  • Free Cash Flow: CHS’s free cash flow is healthy, at $132.8 million, and is a sign of strength for the company. It translates to an attractive Free Cash Flow Yield of about 17%.
  • Debt to Equity: CHS has a debt/equity ratio of .09. This is one of the stock’s biggest strengths, since long-term debt is very low, at only $61.25 million in the last quarter against $228.8 million in cash and liquid assets.
  • Dividend: CHS pays an annual dividend of $.34 per share, which translates to a very attractive yield of about 5.15% at the stock’s current price.
  • Price/Book Ratio: there are a lot of ways to measure how much a stock should be worth; but one of the simplest methods that I like uses the stock’s Book Value, which for CHS is $5.19 and translates to a Price/Book ratio of 1.16 at the stock’s current price. As a value investor, I do like it when I can find a stock that is trading near to its Book Value. However, in CHS’s case, that doesn’t automatically translate to a big opportunity; the stock’s historical Price/Book ratio is only .96, which actually implies the stock is overvalued by nearly 18% and puts the stock’s fair value at only $4.98 per share.

Technical Profile

Here’s a look at the stock’s latest technical chart.

  • Current Price Action/Trends and Pivots: The red diagonal line measures the length of the stock’s downward trend over the last two years to the 52-week low it reached at the end of the year; it also informs the Fibonacci trend retracement lines shown on the right side of the chart. Despite the stock’s rally so far this year, the stock is remains significantly below the resistance shown by the 38.2% retracement line at about $8.50 per share. The strength of the downward trend does imply the stock is more likely to find resistance somewhere between its current price and that retracement line than it is to keep building bullish momentum. That resistance looks to be anywhere between $6 and $7 per share. The stock would need to break above $8.70 to offer any kind of sustainable upward trend, and an actual reversal of the long-term downward trend isn’t likely to be seen unless, and until the stock breaks above that level. If the stock breaks below its recent trend low around $4.50, it could easily revisit lows in the $2.50 to $3 range last seen at the bottom of the bear market in late 2008.
  • Near-term Keys: If you’re looking for a short-term bullish trade, this is a stock that doesn’t really offer a good enough reward: risk ratio to justify the low probability of success right now. That could change if the stock breaks above $8.70, but any kind of swing or momentum-based trade before that point with call options or buying the stock outright would be sheer speculation. Despite the stock’s fundamental strength, I also think there is a real chance we could see CHS drop below $5, and stay there for some time, particularly if the economy does begin to weaken. The fact that the company’s margins have deteriorated so severely, and revenues have declined since mid-2015 despite general U.S. economic health puts CHS on the wrong side of the reward: risk curve. This looks like a classic “dead cat bounce” set up that only a fool would try to work with right now.