Hot Stocks Prove What Goes Up Can Come Down
Gravity still works, as owners of some formerly high-flying stocks have painfully discovered over the past two sessions.
Computer data storage phenomenon Iomega Corp., which has soared from $6 to $55 in recent months, plunged $6.69 on Friday and dropped an additional $5.69 on Tuesday, to end at $38.88. Optical Cable Corp., a fiber-optic cable supplier, sank $18 on Friday and then $14 on Tuesday, to $78. The stock’s peak on Nasdaq on Friday: $136.
The list of other major casualties Tuesday, in a session that shaved only a little from the market as a whole, included recent investor darlings Presstek Inc., MRV Communications, PairGain Technologies, Baby Superstore and PIA Merchandising.
Exactly why the stocks are being hammered now--as opposed to a week ago or three weeks ago--in most cases can’t be answered any more definitively than the question of exactly why they went up as fast as they did. Veteran investors are familiar with the concept of “momentum” stocks, but newer investors may be learning the hard way.
Momentum stocks are issues that can rocket for no better reason than simply because a growing number of investors have discovered them and desperately want a piece of the action. Generally there is an underlying buzz about the business--think of the Internet stock craze last summer, when Netscape Communications went public.
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Lately, the must-own stocks have included a host of telecommunications issues with Internet ties. Optical Cable is in that group, as are PairGain Technologies and MRV Communications.
Good, solid businesses? Maybe. But good enough to merit their stocks rising anywhere from fourfold to tenfold in recent months? Relative to the companies’ earnings per share--the classic market valuation gauge--these stocks were on Mars.
At its peak last week, Iomega was priced at about 133 times estimated 1996 earnings. But momentum players typically don’t care about price-to-earnings ratios. These stocks are roller coasters to be ridden until that big hill, however high, is crested.
Then what? Alan Shaw, long-time market technician at Smith Barney Inc. in New York, notes that the usual pattern when momentum stocks finally crest is “a retracement of a good part of the final parabolic move,” meaning the coaster car up can become a rocket down, back to the price level where lift-off began.
But that doesn’t necessarily spell the end for the stocks, Shaw notes. There can be many subsequent attempts at rallies, if the stories stay hot. Netscape, which zoomed from $14 to $87 last year, ended the year at $69.50, dove as low as $34.75 in winter, and has since fought back to $70.50 now.
Contrary to what many conservative Wall Streeters would argue, momentum-stock investing isn’t necessarily just a fool’s game. Gary Pilgrim, manager of the $4.7-billion-asset PBHG Growth stock fund in Wayne, Pa., owns plenty of pricey stocks. “The stocks that sell for high P-Es [price-to-earnings ratios] often are companies growing 60%, 70% or 80% a year. Who’s to say how high is too high for these stocks?” he asks.
Pilgrim dumps a high-flying stock, he says, when something fundamental changes in the business--not when a particular P-E threshold is crossed. That strategy has worked well enough for him: PBHG Growth was up 262% in the five years ended March 31, versus 95% for the average fund.
Even so, many investors intuitively sense that the action in stocks such as Iomega and Optical Cable is symptomatic of a bull market peak. But how close to a peak are we?
The Minneapolis-based Leuthold Group, an investment research firm, notes an interesting facet of this market: Despite pockets of craziness such as the Internet-related issues, the typical stock is priced at 17 to 18 times its most recent 12 months’ earnings per share. And that 17-to-18 P-E range is consistent for big stocks, medium-size stocks and the smallest stocks, according to Leuthold, which tracks 3,000 issues altogether.
Normally--though not always--at definitive market peaks smaller stocks sell for P-Es well above those of big stocks, as investors see Iomega-style appeal in a broad cross-section of smaller companies, and run their shares up accordingly. So stocks’ current uniform 17-to-18 P-E may suggest that however manic this market appears to be, we ain’t seen nothing yet.
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How Expensive?
Measured by price-to-earnings (P-E) ratios, the biggest U.S. stocks currently are valued about the same as the smallest stocks--quite unlike the normal situation at market tops (such as June 1983) or market bottoms (such as Sept. 1990). Median P-Es for 3,000 stocks, grouped by market capitalization deciles:
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Median P-E ratio: Market cap Sept. June decile Now 1990 1983 1 (biggest stocks) 17.6 14.5 12.9 2 17.0 11.7 13.0 3 17.5 12.0 13.3 4 17.4 11.4 12.9 5 17.7 11.0 13.4 6 18.4 10.0 13.9 7 18.3 9.5 14.5 8 18.0 9.0 15.0 9 18.4 8.7 16.5 10 (smallest stocks) 17.0 8.6 17.0
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P-Es are based on trailing 12-months earnings per share (operating earnings for current reading).
Source: Leuthold Group
