Apple (AAPL) caught Wall Street by surprise last week, issuing a surprise profit warning that sent the stock down roughly 10 percent in one day. For those of you who are long-time Apple shareholders, however, it's nothing you haven't seen before. For all its charms, it is a bimodal (and psychologically bipolar) stock.
Over the last 20 years, Apple shares have had a standard deviation of 42.8 percent per year, clocking in at roughly triple the risk of the S&P 500 at 14.8 percent per year. Yet, over this 20-year period, if you invested $10,000 in the stock and forgot about it, you'd be sitting on a profit of over $3.3 million. You've had 20 straight years of crowded Apple stores, and Apple had a 50 percent higher standard deviation than the stock of General Electric (GE), which would have lost close to half your money over the last 20 years.
Apple vs. S&P 500, 1998-2018 (log scale)
Efficient market theorists would say that the other-worldly returns of Apple stock are a reward for the risk taken. They're partially right, as this is the main reason why the company consistently trades for a low multiple. With that said, I think everyone can agree that the reward has outweighed the risk taken over time for Apple shareholders.
However, we can manage some of the risk of Apple stock using a simple trend-following strategy. The idea is that while returns are unpredictable, volatility is relatively easy to predict. If you're a long-term holder, this can help guide you with regard to favorable times to buy and whether you should let the stock run more before selling. If you're a trader and/or use margin, volatility forecasting actually takes you into the third dimension and predicts your returns. Much in the way that card counters bet more when the deck is stacked in their favor, volatility forecasting tells traders how much risk to take.
Volatility forecasting works well with Apple because the stock basically has two modes that you see over and over again. I'll go through what they are and how you can make money from them.
Mode 1 - Mania
Mania begins when Apple launches a new product and Wall Street begins to salivate over how many the company could sell with its global distribution. Or, perhaps, Apple's ubiquitous TV ads bury themselves in the subconscious minds of traders, who then look up the stock and decide it's cheap.
The truth is, we don't really know what causes the massive rallies in Apple stock. Its fundamentals are consistently good (for example, people are freaking out right now, but Apple still will set an EPS record this quarter), but the sentiment swings wildly based on Wall Street's growth expectations. Mania mode for Apple typically lasts 1-3 years at a time. During manic periods, the company trades above its 200-day moving average almost all of the time.
Mode 2 - Panic
Panic usually begins when Apple starts to see a slowdown in EPS growth. Right now, Wall Street is in a panic about the iPhone being too expensive. A few years ago, Wall Street hated the iPhone C for its supposed effect on the company's overall margins. The story is similar every time. The drumbeat starts in a 6x8 foot cubicle somewhere in Manhattan when an analyst decides Apple can't sustain its margins or sales long term. A research note gets emailed out, and Wall Street knows the jig is up. One analyst downgrades the stock, which knocks the price down and causes more analysts to downgrade, which causes retail investors to panic until the stock completely tanks. During periods of panic, Apple is typically well below its 200-day moving average.
The data shows wave after wave of panic for Apple over the last 20 years. Stages of panic tend to be shorter-lived than mania, but the drawdowns are unusually painful compared to typical drawdowns in the S&P. This can be managed, however.
Timing AAPL Using Statistics
The data shows a clear split in Apple's volatility depending on whether the stock is above or below the 200-day moving average.
As you can see from the test, timing Apple stock based on the 200-day moving average slightly outperformed buy-and-hold. The real kicker, though, was that the standard deviation was cut from 43 percent to 31 percent, and the maximum drawdown was cut from 80 percent to 44 percent (both portfolios' worst drawdowns occurred after the tech bubble burst).
How to Apply This Strategy
Sharp long-term investors are likely to notice that buying and selling Apple would have generated short-term capital gains and killed the benefit of deferring taxes until sale, which is one of the nicest benefits of investing in stocks. If you're a long-term investor, you're still better off with buy-and-hold. However, using the 200-day moving average is a helpful guide to determine when to invest new money and when to sell.
For example, if you're thinking about buying Apple right now, you could know that historically, the company has similar returns above and below the 200-day moving average, but you're likely to experience greater volatility and drawdowns if you buy now. This is true for the market at large also.
If you're one of the lucky ones who has managed to amass millions of dollars' worth of Apple stock, the 200-day moving average can give you an indication of when the best time to diversify away from Apple is or how to time your sales for lifestyle purposes. The best time to do so is when the stock breaks below its 200-day moving average. When Apple is above the 200-day moving average, you typically do better by letting the stock run a little more and being less inclined to sell. If you're a relatively risk-averse investor, you might find it helpful to know that waiting for the 200-day moving average to come down to meet the stock typically yields better risk-adjusted returns than buying during the panic mode.
While investors can help guide their decisions using various volatility forecasting methods, traders can actually take it a few steps further.
For example, by using margin and adjusting the leverage ratio based on the volatility environment, traders are able to apply risk when the returns are most favorable and remove risk when the environment is less favorable. You can beat the market this way. I wouldn't recommend this strategy for retirees, for example, but a risk-tolerant investor might have a moderately aggressive collateral portfolio that could then be used as margin collateral at a place like Interactive Brokers (or any other broker that will lend at 3.5 percent). You could fully invest in your core portfolio and use margin to invest in companies like Apple. The name for these kinds of strategies in general in the hedge fund world is portable alpha.
If your stock picks are above their 200-day moving average, you buy, selling the shares back and paying back the loan when the holdings drop below their moving average and the risk environment changes. This is extremely helpful for margin investors, who have to pay interest when they have positions outstanding (as the net benefit of margin investors reducing positions during unfavorable periods is greater than cash investors going to cash due to the higher interest rates).
Would I personally recommend this portfolio? Not exactly.
I think that inexpensive leverage is better applied to diversified portfolios filled with ingredients like ETFs of dividend stocks, small-caps, and bonds. Equity concentration and leverage are a dangerous combo (doubly so when it's single stock concentration you're dealing with). In fact, you would have blown up your portfolio beyond repair by 2002 by investing in only Apple on full Reg T margin if you weren't smart about managing your risk.
There are a lot of folks on Seeking Alpha who trade actively and/or who use maximum margin to trade individual stocks. If you're in this group, I highly recommend giving some of my volatility forecasting and risk management research a read. Even for conservative investors, understanding how volatility affects the returns of leveraged portfolios is a really nice benefit though, because it helps explain why stocks tend to move in trends.
A better application of volatility forecasting applies to options traders. Since volatility is much higher when stocks are below their 200-day moving average and options are priced off volatility, options buyers also do much better when buying calls on stocks that are above their 200-day moving average. Slightly higher returns and much less volatility in the underlying stock make a huge difference for options buyers, who are able to take much better risks.
I believe investors buying Apple now can expect strong returns. However, buying the stock at times like these has historically caused investors to experience heightened volatility. If you can stomach the volatility, I believe Apple shares are a buy. If you're more of a risk-averse investor, waiting for Apple to break back above its 200-day moving average is statistically a safer play than buying now. If you're a long-time Apple shareholder, you've seen this whole thing before and probably will see it again. Volatility has been the price of admission for one of the greatest wealth-generating stocks in the history of the world.