AAII Investor Update: High Valuations Increase Downside Risk

Thursday, October 27, 2011
Charles Rotblut, CFA
AAII Journal Editor

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High Valuations = Greater Expectations = More Downside Risk

If there was any single financial concept I think investors should remember, it is the one above. The more investors bid up a stock’s valuation, the less room the company has for error. When a highly valued company does disappoint, the drop in a stock’s price can be significant. Netflix (NFLX) and Amazon.com (AMZN) are two examples.

Netflix has been a poster child of how poor management decisions can simultaneously anger both customers and shareholders. As many of you know, the company has been stumbling since July when it announced separate price plans for DVD rentals and online video streaming. (The stock’s price-earning ratio at that time was a pricey 85.) In September, CEO Reed Hastings threw gasoline on the fire by saying DVD rentals would be split into a separate business named “Qwikster.”

This past Monday, Netflix surprised shareholders yet again. The company reported a decline in unique domestic subscribers; in other words, customers canceled their subscriptions. Investors reacted by sending the stock down 35% on Tuesday.

The chart below shows just how much shares of NFLX have fallen. Note that how the upward price movement prior to July 2011 in no way forecast what has happened since mid-July.

Shares of Amazon.com lost 12.7% of their value yesterday after missing third-quarter earnings expectations and giving disappointing profit guidance. Investors were unnerved by the company’s expenditures, such as the money spent on increasing the number of fulfillment centers. Amazon’s new Kindle Fire tablet computer, which was launched last month, also increased costs.

The spending may boost future profits, but with a price-earnings ratio of 103, investors wanted good earnings numbers now. It’s a classic case of a slim margin for error caused by high expectations.

None of this is to say that a highly valued stock can’t rise even further, but rather that with each move higher, the risks also increase. If you are going to ignore a high price-earnings ratio (or a high price-to-book ratio), be cognizant of the potential downside. Eventually, there will be a time when would-be buyers refuse to pay a higher price for the stock.

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Europe and Today’s Rally

European leaders reached an agreement on boosting the bailout fund, recapitalizating banks and asking Greek bondholders to take a bigger cut. Global markets jumped in response, but many details still need to be worked out. Europe is not out of the woods yet, but at least for today, there was progress.

The Week Ahead

More than 100 S&P 500 member companies will report earnings next week. Included in this group are Dow components Pfizer (PFE) and Kraft (KFT), which report on Tuesday and Wednesday, respectively.

The week’s first economic report will be the October Chicago PMI on Monday. Tuesday will feature the October ISM manufacturing survey and September construction spending. The October ADP employment report will be published on Wednesday. Thursday will feature the first estimate of third-quarter productivity, the October ISM non-manufacturing survey, and September factory orders. October employment data, including the change in nonfarm payrolls and the unemployment rate, will be published on Friday.

The Federal Open Market Committee will hold a two-day meeting starting on Tuesday. The meeting statement will be published earlier than usual on Wednesday, at 12:30 p.m. ET. About two hours later, Federal Reserve Chairman Ben Bernanke will hold a press conference at 2:15 p.m. E.T.

Atlanta Federal Reserve Bank President Dennis Lockhart is the only other Federal Reserve official scheduled to make a public appearance. He will speak on Thursday.

AAII Sentiment Survey

Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 43.0%, up 7.0 points
  Neutral: 32.0%, up 2.6 points
  Bearish: 25.0%, down 9.6 points

Long-term averages:
  Bullish: 39%
  Neutral: 31%
  Bearish: 30%

Take the AAII Sentiment Survey »

Bullish sentiment, expectations that stock prices will rise over the next six months, reached a six-month high in the latest AAII Sentiment Survey. Optimism jumped 7.0 percentage points to 43.0%. This is the second time in three weeks that bullish sentiment has been above its historical average of 39%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose 2.6 percentage points to 32.0%. This is the first time in 15 weeks that neutral sentiment has been above its historical average of 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, plunged 9.6 percentage points to 25.0%. This is the lowest level of pessimism since July 7, 2011. Bearish sentiment had been above its historical average of 30% for the previous 14 consecutive weeks.

This week’s numbers are a significant change from the trends we have seen. Bullish sentiment is above average for only the fifth time out of the last 28 weeks. Bearish sentiment is below average for only the fourth time in the past 36 weeks. The spread between bullish and bearish sentiment (the bull/bear spread) is the most positive it has been since February 17, 2011.

Whether this is a distinguishing change in sentiment or just a temporary shift remains to be seen. Pessimism has declined for five consecutive weeks as October’s rebound in stock prices has helped to calm nerves. On the other hand, individual investors remain concerned about the pace of economic growth, the gridlock in Washington and European sovereign debt. (This week’s survey was completed before this morning’s announcement from Europe.) Thus, the optimism signal in this week’s survey is a cautious optimism.

This week’s special question asked AAII members whether they are looking at value, growth or dividend stocks. The overwhelming majority of respondents said they were looking at dividend stocks. Many cited the comparatively higher yields or the cushion against volatile market conditions that dividends offer. A small group expressed a preference for either growth or value stocks, and some said they were currently avoiding stocks altogether.

Here is a sampling of the responses:

  • “Dividend-paying, so I can at least get paid while waiting for an upward market move.”
  • “Dividend-paying stocks. I am retired and looking for income. In addition, these seem to be the safest segment of the market.”
  • “Dividend-paying. They are better than CDs, interest on banking accounts, and many bonds.”
  • “I have been interested in dividend stocks for almost two years. They provide a steady source of income, even in a very unpredictable market.”
  • “Dividend. Yields on these stocks seem attractive.”

Are you bullish, bearish or neutral? Take the AAII Sentiment Survey and tell us.

Wishing you prosperity,

Charles Rotblut, CFA
AAII Journal Editor