Momentum stocks are like playing a game of musical chairs, it can fun and profitable for everyone who plays, until the music stops.
This game ended badly for shareholders recently in stocks like Netflix (NFLX), Green Mountain Coffee (GMCR), Diamond Foods (DMND) and others. The recent plunge in these stocks is proof that in the end, valuation matters. This is not a new lesson but for some reason investors repeatedly forget the lessons of the past.
Cisco (CSCO), Research in Motion (RIMM), Dell Computer (DELL), Microsoft (MSFT), and so many other stocks were also highly-valued momentum stocks and they also proved that paying too much for a stock can mean you earn very little or worse, you can lose 50% or more in just days or weeks when investors sour on a business model and suddenly the stock is forced to trade on valuation rather than momentum.
After a stock loses support from momentum investors, it can plunge and with the momentum class of investors no longer willing to buy, the next group of buyers could be those that buy based on valuation. Imagine being forced to sell your Amazon shares to a value investor. For a stock like Amazon.com (AMZN), the ride down for the stock to achieve any type of reasonable PE ratio would be sharply lower. When you consider that Netflix traded over $300 per share just months ago, and now trades for a mere fraction of that at $76, it illustrates the risks that Amazon shareholders might be facing now.
There are three reasons why Amazon looks ready to drop sharply:
1. The price to earnings ratio is ridiculous and probably unsustainable. With earnings estimates of only $1.20 per share for 2011, and $2.05 for 2012, the PE ratio is way over 100. Other retail stocks don't sell for this type of premium and even few tech companies do. Furthermore, the growth rate doesn't even support this type of PE ratio.
2. The business model is based, in part, on not charging sales taxes to most consumers. This is a game that will probably not last, because a number of lawmakers have introduced plans to force Internet companies into charging sales taxes. State governments are in dire need of revenue and closing this loophole could raise billions in new taxes.
3. Amazon earnings have been disappointing recently and this stock is trading well below the key support level which is the 50-day moving average at $223.32. It is now close to dropping below the 200-day moving average at $200.04 as well. See the chart below which shows the weakness:
Amazon.com, Inc. (AMZN) shares are trading at $204.52. Amazon is an Internet retailing giant and is based in Washington. The shares have traded in a range between $160.59 to $246.71 in the past 52 weeks. The 50-day moving average is $223.32 and the 200-day moving average is $200.04. Earnings estimates for AMZN are $1.20 per share in 2011, and $2.05 for 2012. This is a great company with incredibly smart management, but at about 140 times earnings, investors are probably paying too much for the potential growth. I won't be surprised to see Amazon shares hitting new 52 week lows in the next few months.
The data is sourced from Yahoo Finance and Stockcharts.com. The information and data is believed to be accurate, but no guarantees or representations are made. Rougemont is not a registered investment advisor and does not provide specific investment advice. The information contained herein is for informational purposes.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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