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Momentum Stocks Drive Market Higher

By Jim Pearce on July 14, 2017

As someone who reports on the stock market for a living, I spend a lot of time studying a wide range of empirical data to determine fair value for investments. I stick to numbers to avoid getting swept up in the euphoria driving a hot stock to unimaginable heights, especially when the company in question is unprofitable and may never achieve the outsized expectations justifying its huge share price.

That’s why I have never owned stock in electric car maker Tesla (NSDQ: TSLA), even while its share price doubled from below $190 last December to above $380 last month. I simply don’t know how to place a reasonable valuation on a company that has never made a profit and isn’t sure when it ever will, since profits are the only financial result that can be shared with stockholders.

That may also explain why Tesla’s share price quickly dropped 20% this month after the company acknowledged it couldn’t meet its ambitious vehicle delivery schedule due to a production shortage of battery packs. But Tesla is far from alone in being susceptible to huge price swings based on overly optimistic projections.

The quartet of high-tech “FANG” stocks consisting of Facebook (NSDQ: FB), Amazon (NSDQ: AMZN), Netflix (NSDQ: NFLX), and Google (now Alphabet (NSDQ: GOOGL) is driving the stock market to record heights, despite the fact that two of them are only marginally profitable. While Facebook and Google trade at relatively modest premiums to the overall market based on their actual net income, Amazon and Netflix are priced at earnings multiples nearly eight times that of the S&P 500 Index.

Even if future profit expectations come true, they have to be discounted to a present value based on assumptions for inflation. With the surprisingly strong June employment report reflecting continuing strength in the economy, it is likely the Fed will stick to its plan to raise interest rates into next year to keep inflation in check.

That means future profits must be discounted at a higher rate, which is more bad news for companies like Tesla that don’t have any current profits to factor into the equation. And if future profits don’t materialize as anticipated, then the rate at which they are discounted is immaterial.

Along a similar vein, I was not surprised when retailer Target (TGT)  announced this week that it is upping its profit forecast for the current quarter. In fact, in the current issue of Personal Finance I feature Target in my Growth Track story as the type of company that will be able to successfully fend off Amazon.

Amazon is in a flimsier position than Tesla since it has no intellectual property of particular merit that prevents a competitor from offering an essentially identical service. And with Wal-Mart, Target and other retailers investing heavily in online sales and distribution, it’s entirely possible that one or more of them may eventually usurp Amazon as the online vendor of choice.

Don’t think that could happen? A lot of people also thought Blackberry (BBRY) had a stranglehold on the smartphone market ten years ago, until a company by the name of Apple decided it could make something better. And early social networking butterflies were exchanging cookie recipes on MySpace long before Facebook became a thing.

The problem with betting big on future profits is that they don’t always happen, a lesson dot.com investors learned the hard way sixteen years ago when that market imploded. I don’t expect all the FANG stocks to follow suit, but I do believe that some of them will experience a severe downward price adjustment in their share prices when future profits become more definable.

Until then, owning stocks like Tesla and Amazon is effectively an exercise in the “greater fool” theory, so-named because it depends on current shareholders finding investors even more optimistic than they to sell their stock to at inflated prices.

You don’t want to be that person.

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