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International Paper (IP) has two qualities that make it a strong prospect for bulls right now. First, the company has been outperforming the S&P 500 in profit growth and is poised to do even better if the economy turns the corner – even temporarily. They have surprised analysts with better earnings six out of the last seven quarters and are due to release earnings again later in July. A close peer, Rock-Tenn (RKT) released their own earnings report the morning we finalized this analysis and surprised to the upside on very strong orders for corrugated cardboard packaging.

Second, the company offers a higher than average dividend (3.42%) that is paid consistently. Dividend yielding stocks have become a crowded trade lately, so finding something like IP that is just breaking out to the upside is rare. When dividends are included in total performance, IP has outperformed the S&P 500 since 2007, which is why income bearing investments have begun regaining much of their former glory.

In a quiet market IP has seen surprising bullish volume

We would consider IP a cyclical/industrial stock, which means that its trend should be fairly correlated with the broad market indexes, however, the stock tends to move up faster than the average. Recently, IP formed a double bottom, which was completed July 13th and is a bullish short term signal. Unlike many other stocks in the market, this breakout has been accompanied by much higher than average volume, which indicates that there is significant buying momentum behind the breakout. In the next chart you can see the double bottom we are watching and our two short term price targets.

International Paper (IP) Double Bottom: Chart Courtesy of MetaStock

The first price target for IP is based on the depth of the double bottom itself. That target is roughly equal to $33.50 and is within shouting distance of the bottom of April’s price gap. There is a high likelihood that this could turn into a resistance level and it is where we would suggest traders apply some coverage to a long position by selling calls, tightening stop losses or simply taking profits.

If the stock is able to break above April’s gap we expect that March’s highs will act as a second level of resistance. The amount of time we expect a move of that size to take would put the stock at this high just about the same time 3rd quarter earnings are due. The short time-horizon may make this trade more ideal for option traders than long term stock investors.

Shipping and transport stocks could be very supportive for IP

Like most stocks that move higher faster than the market average, they tend to move down faster as well. This issue is sometimes referred to as “beta” and is generally unavoidable. This means that we have to watch for signs of weakness more carefully than we might otherwise. We have access to a very helpful tool for identifying emerging weakness in industrial stocks called Dow Theory.

Dow Theory was developed by Charles Dow (of Dow/Jones and Wall Street Journal fame) over a century ago and consists of several methods of technical analysis that are still applied by successful technicians today. One of the concepts of Dow Theory suggests that transportation stocks will lead industrial stocks to the upside and the downside. In the past, transport stocks have been more predictive of decline than a rise, but that is just as helpful.

Right now transportation stocks as represented by the Dow/Jones Transportation Index are flat and have been trending flat since January. So far, support has remained intact, but the index has been in a mild contrarian-decline and it could break. We know that a price move like that would tell us to get out of IP; or at least apply more aggressive risk control. In the next chart you can see IP in green and red versus the Dow/Jones Transportation Index in black.

Dow/Jones Transportation Index vs. International Paper (IP): Chart Courtesy of MetaStock

Besides two fakeouts in May and early June, the transportation index has been above support for most of the year. The relationship between IP and transport stocks is remarkably close. This makes sense if you consider that transport stocks are largely shipping paper and paper packaging.

Options Alternative

Despite the fact that IP has a high beta, option volatility is relatively low. This keeps the cost of the options low in terms of premium inflation. Timing for an option entry is a little tighter than normal because IP reports 2nd quarter earnings on July 26th before the market open. We would expect option premiums to start inflating after July 23rd and would avoid entering the trade between that date and earnings.

We recommend buying the October, 2011, $32 Calls for $1.80 per share or less before July 23rd. That option won’t expire until 3rd quarter earnings are due, which gives the trade long enough to complete if everything goes well. If the stock gets to $36 by expiration the return would be over 100% on the option but only 14% on the stock. Of course, an exit before expiration at the same price level would be an even larger profit.

Chart courtesy Finviz. Click to open in larger window.

This is not investment advice. Learning Markets, LLC is not responsible for errors or omissions. Please be sure to read our disclaimer.