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Momentum Takes a Breather

By Elliott H. Gue, on Apr. 7, 2014

Momentum favorites that led the broader market higher in the fourth quarter of 2013 and the first quarter of 2014 have been leaders on the downside over the past month. We’ve been warning investors of the downside risk in several of these hot stocks with nosebleed valuations for weeks.

Sensationalist headlines in the financial media have been crowing about the big sell-off in stocks in recent weeks but the pressure has been surprisingly concentrated in some of the market’s most highly valued groups.

The Nasdaq Composite and Nasdaq 100 fetch 2.1 and 2.8 times trailing 12 months revenues respectively compared to just 1.7 times for the S&P 500 and 1.2 times for the S&P 600 SmallCap Index. The Composite and Nasdaq 100 are both off around 6 percent since hitting 52-week highs on March 6 compared to a less than 2 percent sell-off in the S&P 500 over the same time frame.

And the S&P 600 Index, known for lagging in a weak market, is also holding up better than the Nasdaq, down about 3.7 percent over the past month.

We did a simple screen for stocks in the Nasdaq Composite or S&P 500 with a market capitalization over $1.5 billion that have performed better than the average stock over the trailing 12 months but have a price-to-sales ratio over 10 times.


Source: Bloomberg

The 23 stocks on this table are up an average of 167 percent over the past year, outperforming the Nasdaq Composite’s 28.1 percent gain by a near 6-to-1 margin. But, it’s not hard to see that these former market darlings are the source of much of the Nasdaq’s recent weakness — the average stock on the list is down about 19 percent over the past month.

The list includes stocks like Tesla Motors (NSDQ: TSLA), the overvalued electric car manufacturer in the March 17 and March 24 issues of Big Picture “Tesla Motors: The Car is Electric, the Stock is Not.”

Even after the recent slide, Tesla trades at more than 12 times revenues, a valuation that prices in the best possible news on future sales, profit margins and cost estimates. Based on our analysis, there’s no room for error or even a slight profit miss in a stock like Tesla without a significant downside reaction in the stock.

That’s far too much confidence to put in a company selling what is still a largely unproven product. After all, while the Tesla Model S has been popular with consumers willing to shell out $100,000 for a new car, much of the stock’s inflated valuation is based on projected sales of the cheaper mass market Gen III to be introduced in 2017.

But, it’s unclear if the Gen III, priced at close to $50,000, will appeal to consumers who also have the option of purchasing more fuel efficient gasoline-powered vehicles at half that cost. Our view remains that this is a tall order.

The same can be said of SolarCity (SCTY), a solar company my colleague Roger Conrad profiled at length in the January 17, 2014 issue issue of Income Insights “The Smarter Bet on Solar.”

Momentum names tend to trade based on support and resistance levels on the charts over the short to intermediate term rather than fundamentals. Technically, if Tesla takes out its late March low at $203 on a closing basis, the stock could rapidly fall toward support at its 200-day moving average under $170. As we detailed in the March 17 and 24 issues, we’d continue to avoid Tesla.

Solarcity could easily trade toward $40 amid a continued sell-off, a level it last tested in early October.

But while crumbling momentum in groups like biotechnology and stocks like Tesla and SolarCity will likely drag the Nasdaq lower over the next month or two, we continue to find value in other sectors and stocks. The market is not overvalued from a broader perspective – the S&P 500 currently trades at roughly 17 times trailing earnings, only slightly above its post-1954 average of 16.25 times.

Moreover, the US economy continues to show signs of accelerating growth. Last week the ISM Manufacturing Index came in at 53.7 up from 53.2 in the prior month. Any level above 50 indicates growth in the manufacturing sector of the economy and the strong bounce-back in PMI after a big dip in January suggests distortions caused by extreme cold weather this winter are beginning to fade.

Even more encouraging is that the ISM’s New Orders Index jumped from 54.5 to 55.1 in March. Since manufacturers typically wait for an uptick in orders to increase output, strength in this component of PMI suggests we’ll see continued strength in manufacturing activity over the next few months.

And last Friday, the monthly Employment Report showed a 192,000 jump in private non-farm payrolls, in-line with estimates for an increase of around 200,000 jobs.

And one troubling trend in the employment data in recent years has been a significant drop in the so-called labor force participation rate, a measure of the percentage of the population that’s considered part of the labor force. This slide reflects an aging population and subpar economic recovery after the Great Recession. But, in a robust labor market, rising wages fuel an increase in the labor participation rate; the opportunity to collect a solid paycheck would draw more people into the workforce.


Source: Bloomberg

While the post-2009 downtrend in the labor force participation rate is hardly broken, the recent uptick in this measure suggests it may have bottomed in this cycle. That would be an encouraging sign that strength in employment and wages is beginning to attract more people into the workforce.

Against that solid economic backdrop, it’s unlikely the S&P 500 will see more than a 5 to 10 percent pullback. Such a move would be a healthy bout of profit-taking after a significant run-up in the broader market over the past year.

In Capitalist Times Premium, we recently recommended taking profits on Adobe Systems (NSDQ: ADBE), the firm behind the popular Adobe Acrobat and Creative Suite web design software. While we believe in Adobe’s long-term growth potential, the stock was up more than 35 percent since our original recommendation in late July 2013 would be vulnerable to profit-taking amid a broader market sell-off.

But our sale of Adobe Systems was tactical in nature, not strategic. Over the next few weeks, we’ll be looking for opportunities to buy the dips in stocks in our favored sectors including energy, industrials and basic materials.

And while pundits argue over the valuation of busted momentum stocks like Tesla, our latest CT Premium portfolio addition is a stock in one of America’s oldest industry groups. While the US was a global leader in this business for more than a century, by 2000 most pundits had assumed that the US was destined to lose out to countries with lower wages like China.

But nothing could be further from the truth. Our favorite manufacturer is a market leader in a new technology that’s dramatically cutting costs thanks to America’s abundance of low-cost natural gas. Even better, this savvy industrial titan has effectively locked in its low natural gas costs for years into the future by partnering with one of North America’s largest producers.

The company’s latest facility opened up on the Louisiana coast on Christmas Eve and as output ramps up, profit margins will begin to soar, pushing the stock sharply higher. Don’t wait until it’s too late to jump aboard – try out a risk-free 30-day subscription to Capitalist Times Premium today and find out about out latest recommendation, poised for gains of as much as 50 percent over the next 6 to 12 months.

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