One Way to Catch a Falling Knife

By David Sterman
June 03, 2010

With earnings season now over, stocks are trying to readjust toward their true value.

Price targets are often simply a function of multiplying projected earnings against an appropriate price-to-earnings ratio (P/E) multiple. Generally, to determine an appropriate P/E, analysts try to strike a balance between a company’s newly-revised earnings growth rate and the P/E multiple that the stock has historically garnered.

If a company recently beat estimates, shares should rise to reflect the newly-raised earnings outlook.

But when a company delivers weak profit results and/or a disappointing profit outlook, the game isn’t quite so easy. While analysts scramble to set new lower price targets, large holders of the stock, like mutual funds or hedge funds may decide to simply unload the shares,  since the justifications for owning the stock no longer hold water. Mutual funds tend to amass such large positions in a stock that they need to exit their position in a steady and orderly fashion. But hedge fund managers often just dump their entire position at a moment's notice. By the time the selling is over, shares may overshoot on the downside, below the point where analysts predicted they would fall.

This thought came to mind when Priceline.com (Nasdaq: PCLN) shed another $5 on Thursday. Back on May 11th, Priceline.com warned that the traffic-impeding volcano in Europe and political chaos in Thailand would lead to a drop in demand for travel. Shares, which had already fallen from a high of $273 to around $260, plunged another $40 that day to close right around $219.

Conveniently, that was right where some analysts set their lowered price targets. The combination of a slightly lower earnings growth rate and a new lower earnings forecast led worked out to a price target of $200 to $220, according to several analysts.

But shares didn’t stick to the script. A week later, they fell below $200, a week after that below $190, and PCLN shares are now fast approaching the $180 mark. Simply put, an abundance of sellers and a dearth of buyers are driving shares down well below where many thought the stock would find a floor.

But according to the logic of Wall Street, shares will soon rebound. And here's why: At some point, the sellers will be fully flushed out of the stock. Then the analysts will come out to defend their price targets, arguing that earnings are still expected to grow nicely, and the P/E ratio, which has now fallen by a third, has come down too far.

Indeed, that’s already happening with Priceline.com, though few are listening at this point. In late May, both Soleil Securities and KeyBanc came out with ratings upgrades on Priceline.com, setting price targets of $230 and $260, respectively. Then earlier this week, analysts at Susquehanna also came to Priceline’s defense, reiterating a $260 price target. In coming days, you’ll probably see more analysts noting that shares of Priceline have taken too much of a hit -- especially since the Icelandic volcano and the unrest in Thailand are no longer dominating the headlines.

As the analyst chorus becomes more positive, the stock chart should soon follow.

Action to Take --> Wall Street pros often have a surprisingly simple approach that any individual investor can replicate. They find stocks that are farthest from their price targets, and then simply wait until the sellers have been flushed out of the stock. When they see the targeted stock moving sideways for several sessions, they pounce. Indeed, many of the same funds that sold Priceline.com back at $250 probably find shares more appealing now that they're close to $180, and they'll be looking to buy back in.